The Fed cuts interest rates, "the shoe drops" on the US economy, and the narrative of a "soft landing" becomes the focus of the market again

This week, the Federal Reserve held its most important meeting in recent times, with all investors' attention focused on one question: whether the Fed has timely initiated an interest rate cut cycle to prevent the economy from slowing too quickly.

On Wednesday, as scheduled, the Fed announced a rate cut, lowering rates by 50 basis points. This is the first time in over four years that borrowing costs have been reduced, with the Fed assuring investors that this significant rate cut is to protect the resilient economy, rather than an emergency response to recent weakness in the labor market. In the days leading up to the meeting, the market's bets on the magnitude of the rate cut had been fluctuating, with probabilities almost evenly split until Wednesday morning.

The extent to which Fed Chair Powell's outlook materializes may be a key factor influencing the stock and bond market trends for the remaining time in 2024.

The prospect of a "soft landing" has boosted the stock and bond markets this year, but signs of weakness in the labor market have raised concerns that the Fed's actions may be too late.

Eric Beyrich, Co-Chief Investment Officer at investment advisory firm Sound Income Strategies, said, "At the moment, the market seems to be pausing to digest the surprising news for many. Some are still wondering, 'Wow, if the Fed cuts rates by such a large margin, do they see signs that the economy will worsen that we haven't seen?'"

The market's reaction on Wednesday was relatively mild, with U.S. stocks, Treasuries, and the dollar giving back their initial gains after the Fed's decision. The S&P 500 index fell by 0.3%, after rising by as much as 1% intraday. The index has risen by nearly 18% this year, nearing its historical high.

In post-rate decision comments, Powell described the move as a "re-calibration" to explain the sharp decline in inflation since last year, stating that the Fed aims to stay ahead of any potential weakness in the labor market.

Some investors are skeptical of this optimistic view.

Josh Emanuel, Chief Investment Officer at Wilshire, said, "Despite what Chairman Powell said at the press conference, the 50 basis point change does indicate concerns that they are falling behind the curve."

Emanuel mentioned that he had increased bond holdings before the meeting, preferring investment-grade credit over riskier high-yield bonds until the economy deteriorates.

However, many others view the rate cut as a positive development for the market, which will boost the economy.

Jeff Schulze, Managing Director of Economic and Market Strategy at ClearBridge Investments, said, "I think this significantly increases the Fed's ability to achieve a soft landing, which will ultimately benefit risk assets."

In fact, as long as the economy does not fall into a recession, the stock market performs well after rate cuts. Data from Evercore ISI since 1970 shows that in the six months following the Fed's first rate cut, the S&P 500 index has on average risen by 14% during non-recessionary periods of Fed rate cuts. In contrast, during periods of economic recession following the first rate cut, the index has fallen by 4% over the same period.

Rick Rieder, Chief Investment Officer for Global Fixed Income at BlackRock, suggested that investors may be overreacting to the recent lower-than-expected labor market report. Other data, such as estimates of Gross Domestic Product (GDP) growth, continue to show the economy's resilience He said, "I think the market is once again ahead of itself in interpreting very soft data. Powell said the U.S. economy is very solid, and indeed it is."

Fed officials also updated their views on interest rates in their latest June forecasts. While they now expect a larger rate cut, these rate forecasts are still higher than the market's expectations for the Fed to adopt a more accommodative policy.

The Fed stated that it expects the federal funds rate (currently in the range of 4.75% to 5%) to reach 3.4% by the end of next year, while rate traders are betting on around 2.9%. In addition, the Fed's endpoint for rate cuts has been slightly raised from 2.8% to 2.9%.

This divergence may have triggered a reversal in the U.S. bond market, leading to selling of long-term bonds on Wednesday. The yield on the benchmark 10-year Treasury note is currently hovering around 3.73% after touching its lowest level since mid-2023 earlier this week.

Vanguard Group's U.S. Treasuries and TIPS director John Madziyire said, "In terms of the speed of rate cuts, I think this is a correct response." He is betting that long-term bond yields will rise.

Others are looking further ahead, with some pointing out that the outcome of the U.S. presidential election could complicate the path of future rate cuts.

Andrzej Skiba, head of U.S. fixed income at Royal Bank of Canada Global Asset Management, said, "If a trade war erupts during Trump's presidency, it could have a negative impact on fixed income. This would lead to inflation and limit the Fed's ability to cut rates."