Fed rate cut is a double-edged sword, traders worry it will reignite the trend of high inflation

After a day when worries about a US economic recession swept through global financial markets, some situations have become clearer.

According to the Wise Finance app, inflation concerns have receded to a secondary position of interest for traders and investors. Many market participants still hope for multiple rate cuts by the Federal Reserve. As of Tuesday, they expect at least a 200 basis point cut by September next year. However, if the Federal Reserve does cut rates significantly as currently expected by traders, it may trigger a series of new issues.

Federal Reserve rate cuts are a double-edged sword. On one hand, lowering the benchmark interest rate from the current level of 5.25% to 5.5% can help counter the deflation or inflation deceleration pressures that may arise from an economic slowdown. On the other hand, rate cuts may stimulate risk investments in the stock market, reignite worrying inflation trends similar to the wealth effect seen in the first half of 2024, and boost consumer demand. However, this point is still controversial.

Gang Hu, Managing Partner and Trader at New York hedge fund WinShore Capital Partners, said, "The real issue the market hasn't considered is whether the Federal Reserve rate cuts will worsen inflation rather than improve it."

All of this will depend on the economic conditions when the Federal Reserve starts and continues to cut rates, much of which may be speculative. Hu said, "If the market believes the Federal Reserve is behind the curve, rate cuts will be to counter deflation pressures from an economic slowdown. If the Federal Reserve is seen as being ahead of the curve, rate cuts will provide stimulus to an economy that doesn't need it, and inflation will rise."

On Monday and Tuesday, the information conveyed by Treasury securities adjusting principal and interest payments for inflation leaned more towards concerns about an economic slowdown. According to Tradeweb data, yields on 5-year, 10-year, and 30-year US Treasury Inflation-Protected Securities all closed below 2% on Monday for the first time since early March. As of 3 pm Eastern Time on Tuesday, the yields on 5 to 10-year TIPS were around 1.8%, while the 30-year TIPS yield was slightly above 2%, as the broader market recovered from Monday's US stock market plunge.

In addition, fixings traded on Tuesday showed that the headline inflation rate based on the Consumer Price Index is expected to continue to decline to below 2% in the first half of next year.

According to data from the CME FedWatch Tool, most federal funds futures traders believe the Federal Reserve will cut rates by at least 100 basis points by the end of the year, to between 4.25% and 4.5%. They also believe there is close to a 75% chance of another 100 basis point or more cut by September next year, which would bring the federal funds rate target to between 3.25% and 3.5%, or even lower.

Tim Magnusson, Chief Investment Officer at Garda Capital Partners in Minnesota, said, "The Federal Reserve has ample reason to cut rates as the market currently expects, or even more," although what actions policymakers ultimately take remains to be seen. "The market believes the Federal Reserve has achieved its goals, and I have no objections to that." With the unemployment rate rising to 4.3% in July and the market-based inflation rate below 2%, Magnusson said, "The Fed can now cut interest rates, and it is completely reasonable for them to do so." The stock market sell-off on Monday reflected policymakers' view that they are behind the curve, "the days between now and the next Fed meeting will feel like an eternity for market participants."

In Hu's view, lowering borrowing costs from a 23-year high to levels expected by federal funds futures traders could come at a high cost. Multiple Fed rate cuts would "greatly boost asset prices, support home prices, increase inflation pressures, and attract off-market funds," he noted, although the Fed's 25 to 75 basis point rate cuts this year may have little impact on the economy and inflation.

The U.S. economy grew at an annual rate of 2.8% in the second quarter, with over 100,000 jobs added in July, "there is a lot of liquidity in the system," Hu said. Once the Fed starts cutting rates, "you will see inflation stabilize and possibly rise again. The question remains whether this will generate inflation that makes the Fed uncomfortable once again."