The Fed's battle against inflation enters its final stage! But the risks should not be underestimated?

Signs of easing inflation are allowing the Federal Reserve to do something investors have been waiting for a whole year: the first rate cut since the most aggressive rate hike cycle in the past 40 years starting from March 2022.

Federal Reserve Chairman Powell is facing what seems like an impossible task: achieving a decisive victory without pushing the world's largest economy into a recession, or at least avoiding a deep and prolonged recession.

After the U.S. stock market soared to record closing highs last week, investors are facing significant risks. The S&P 500 and Nasdaq Composite indexes closed at record highs for the 37th and 27th time this year, respectively, at 5633.91 points and 18647.45 points last Wednesday. Prior to this, Powell testified before Congress, indicating he was closer to a rate cut.

Powell reiterated his view that policymakers are facing a complex situation: too little or too late of a rate cut could disrupt economic activity, but too much or too early of a rate cut could undermine progress on inflation. The Fed's mandate is to promote full employment and stable prices.

The market believes the possibility of a rate cut by the Fed in September has increased, with all three major U.S. stock indexes rising last week. However, the S&P 500 and Nasdaq indexes closed lower on Friday than the record levels set on Wednesday.

Eric Sterner, Chief Investment Officer at Apollo Wealth Management, said, "This could be related to a hard landing, we may see rising unemployment, reduced consumer spending, more layoffs, and the possibility of a bear market, that is, profit and economic recession."

Sterner added, "Nevertheless, my basic expectation is a soft landing, as both small and large companies are optimistic about earnings prospects for the next two years, with all 11 sectors of the S&P 500 potentially achieving positive earnings growth in the fourth quarter, something that has not happened since 2021."

The Fed's rate hike cycle in the mid-1990s and subsequent rate cut cycle provide a "blueprint" for Powell on how to achieve a soft landing, although some strategists are concerned about the extent of any recession.

In 1994, under then-Fed Chairman Greenspan's leadership, the Fed raised rates by 2.5 percentage points to 5.5% from 3% to cool down the overheating labor market and control inflation.

John Velis, a strategist at BNY Mellon in New York, said this was the first time in decades that policymakers were able to contain inflation without triggering a recession, and the only time.

After another 50 basis point rate hike in early 1995, raising the federal funds rate to 6%, Fed officials cut rates by 25 basis points in July 1995, December 1995, and January 1996 to prevent any potential recession. Despite the S&P 500 rising at the time, they still did so Until March 2001, a year after the bursting of the Internet bubble, the U.S. economy had been in expansion mode, successfully weathering multiple interest rate hikes and cuts by the Federal Reserve between 1997 and 2000, as well as the 1997 Asian financial crisis, the following year's Russian turmoil leading to ruble devaluation, and the collapse of a hedge fund called Long-Term Capital Management (LTCM).

Lawrence Gillum, fixed income strategist at brokerage firm LPL Financial in Charlotte, North Carolina, said, "Walking a tightrope between avoiding recession and curbing inflation is very difficult. Although there may be adverse outcomes, you have to say 'so far, so good.' You might say, a soft landing, or a perfect anti-inflation, has already been priced in. In any other case, whether it's a hard landing or an economic recession, risk assets could suddenly wake up."

Over the past year, the federal funds rate has remained between 5.25% and 5.5%, enough to start impacting the economy. Weak first-quarter GDP growth, downward revisions in job growth, and cooling June CPI data in the U.S. all prove this point. A batch of economic data scheduled to be released this week includes the June U.S. retail sales report released on Tuesday, which will provide clues to the performance of U.S. consumers.

Gillum said over the phone, "Currently, there is a significant risk in cutting rates too late, and even so, rate cuts are 'absolutely' a risk for the stock market, as rate cuts could ultimately reignite inflation. Our view is that the U.S. still has sticky inflation and it will take some time to return to the Fed's 2% inflation target. I have been telling clients that it is unrealistic to price in the Fed's expected three rate cuts this year. We expect the Fed to cut rates twice this year."

At the beginning of the year, federal funds futures traders expected the Fed to cut rates 6 to 7 times by 2024, but later revised down these expectations. Now, they believe that by June next year, the Fed is very likely to cut rates 5-6 times, by 25 basis points each time, with the first cut coming in two months. Meanwhile, San Francisco Fed President Daly expressed support for rate cuts after last Thursday's CPI data release.

Sterner initially believed that the U.S. needed an economic recession to cure inflation, but he has now changed his mind. He said:

"What's different about this cycle is that consumers continue to spend in the face of high inflation because they have accumulated significant savings during the COVID-19 pandemic; fiscal stimulus has boosted government spending; private credit funds have intervened, providing loans to keep medium-sized businesses operating."