- Markets are waiting for the Fed to cut interest rates next year.
- However, this is a difficult situation for investors as the cuts are likely to come in response to the economic slowdown.
- Rate cuts are not bullish in nature and there are signs of economic slowdown towards the end of the year.
Markets are happy that the Federal Reserve will start cutting interest rates next year, but rate cuts are a double-edged sword, warn Wall Street experts, because of what this move would mean for the wider economy.
As inflation declines and the Fed continues to hold off on further increases to its benchmark rate, investors have raised their expectations that the central bank will cut interest rates in 2024. Markets are pricing in the risk that interest rates will be lower than current levels in level of 95%. by December next year, according to the CME FedWatch tool. That optimism was fueled this week by Tuesday’s cooler-than-expected inflation report, in which prices in the economy rose 3.2% in October, below the expected 3.3%.
“I think it makes a difference. “It’s a day of rational exuberance as the data clearly shows what we’ve been waiting for,” former PIMCO chief economist Paul McCulley told CNBC this week. “I think what this leads to is that the Fed can now confidently say that policy is tight enough, and that’s a big deal because it means it’s done tightening policy and the next move will be easy.”
However, interest rate cuts may not be the decidedly bullish catalyst that markets are hoping for. This is because any easing of Fed policy would likely be in response to an economic slowdown, and truly deep cuts would likely occur as a result of an outright recession.
Markets are anticipating a Fed interest rate cut that will trigger a rise in stock prices. However, recessions are generally a strong tailwind for stocks. If the economic situation deteriorates, shares could fall by as much as 20%, JPMorgan’s chief market strategist estimated last month.
“Where is the puck going? “I think it’s passing through soft landing, Goldilocks landing territory right now, but it’s on track for an economic slowdown,” said Chris Grisanti, chief equity strategist at Mai Capital Management in an interview this week. “Rates are not peaking for good reasons. “They are peaking for sad reasons for equity investors… namely the slowing economy, which I think will be evident over the next three to six months.”
The Fed has cut interest rates ahead of the recession in five of the last 10 economic downturns, according to Deutsche Bank strategists.
“This shows that interest rate cuts do not automatically prevent economic downturns, but are often a sign of problems to come.“ – the bank said in a note on Thursday.
According to UBS, interest rates could ultimately be cut by 275 basis points the economy will fall into recession in the middle of next year. That’s about four times the drop in interest rates the market is expecting, meaning the economy could slow to a level at which the Fed feels it needs to reverse much of the tightening of monetary policy implemented since March 2022.
The cuts will be “a response to the projected US recession in Q2-Q3 2024 and the ongoing slowdown in both headline and core inflation,” UBS strategists warned in a note on Tuesday.
There are signs of slowdown in pockets of the economy. Atlanta Fed economists expect real GDP growth will be approximately 2.2% this quarter. This is a dramatic slowdown compared to the 4.9% growth recorded in the last quarter.
Retail spending also fell 0.1% last month, according to U.S. Census Bureau data. This is the first decline in retail spending since March this year and it is a sign U.S. consumers, who helped prop up the economy this year, may finally be starting to lose steam as their savings dwindle.
The decline in spending is deepened by, among others, cooling of the labor market. The economy added 150,000 jobs in October, a significant decline from September, as the unemployment rate rose to 3.9%.
These job numbers suggest that the labor market is close to triggering the Sahm Rule, a highly accurate recession indicator that flashes when the three-month average unemployment rate rises 50 basis points above the lowest level of the previous 12 months.
“We are not in a recession, and yet we are well closer to flashing red on the gauge and there is no promise that we will avoid a recession in the future,” former Fed economist and Sahm government founder Claudia Sahm told CNBC last week.