"Fade trade" overheated? Interest rate pricing does not show that the Federal Reserve is "behind the curve"

The US stock market experienced violent fluctuations and crazy recession trading last week, giving the market an ominous feeling that the Federal Reserve is lagging behind the situation. Senior financial market expert Mike Dolan pointed out that although the Fed's rate cut may be a bit late, it has not fallen behind the curve in preventing a US economic recession. Moreover, the interest rate market has not yet digested the Fed's possible implementation of emergency loose monetary policy stance to save the market within the next two years at any time during the loose cycle.

Market rate cut expectations quickly heat up, but neutral rate expectations do not reflect deep recession

Last month's unexpected sharp rise in the US unemployment rate clearly frightened the market, and the volatility of large tech stocks further exacerbated market panic. With soaring volatility, the market has been pricing in a series of significant rate cuts by the Fed in the coming months.

The US stock market is increasingly concerned that the Fed is behind the curve and should have started cutting rates. The Fed has no plans to hold rate-setting meetings in August or October, reducing its flexibility to make policy adjustments at regular meetings, exacerbating these concerns. Out-of-meeting policy adjustments are possible but rare, usually for emergencies.

Just a month ago, futures prices indicated that the Fed was expected to cut rates twice by 25 basis points for the remainder of the year, but now bets have risen significantly - the latest statistics on Tuesday show that the market expects the Fed to cut rates by about 115 basis points this year. In a series of hasty expectation revisions, the most notable is that JPMorgan currently expects the Fed to cut rates by 50 basis points in September and November, and by 25 basis points in December.

There is now no doubt that the Fed will start cutting rates next month: it sent a very clear signal at last week's meeting. However, the extent of the rate cut is not so clear.

But in the case of the further end of the yield curve, perhaps it can better explain investors' expectations for the entire loose cycle in the future. Futures and currency market prices on Monday show that the so-called terminal rate for the next 18 months has never been below 2.85%, even during the most severe market turmoil on Monday. This is far from the current policy midpoint rate of 5.38%.

However, this is still higher than the long-term "neutral" rate level believed by Fed policymakers - the rate level R* widely seen as neither stimulating nor inhibiting economic activity. After being raised by 30 basis points by Fed officials this year, the median of the Fed's long-term rate forecast considered as the neutral rate is 2.8%.

The interest rate market may not even reflect the impact of a deep recession at all. Therefore, if the anxious money market does not believe that the Fed will be forced to cut rates below this level, then the future US economic slowdown should not be so bad - despite recent recession concerns. At the very least, this indicates that the market still holds an ambiguous attitude towards economic recession, believing that lifting "restrictive" policies itself may be enough to hold the line Although this may highlight investors' lingering concerns about sticky inflation, it is more likely to reflect their doubts about some form of deep recession actually brewing. Data suggests that the market believes the Fed only needs to take its foot off the brake to maintain expansion. The U.S. labor market is indeed weakening, but the economy is not in trouble - U.S. GDP in the second quarter grew at an annual rate of 2.8%.

Even with the current market's expected rate cut, the actual interest rate has not fallen to the "negative level" of emergency relief

Another way to look at the issue is to consider the inflation-adjusted "real" policy rate of the Fed, currently at 2.5%. This is the highest level in 17 years. Since April 2023, as the anti-inflation process began, the real policy rate has steadily risen from zero.

If the entire Fed easing cycle is proven to be a 250 basis point rate cut as implied by the market this week, and consumer price inflation remains at a high of 3% during this period, the real policy rate will return to zero. The average real policy rate over the past 15 years has been -1.4%, so returning to zero does not mean the Fed is heading into emergency mode.

Fed officials' speeches this week suggest that they are not too worried about an economic recession yet, but in terms of policy, everything is still under discussion. They also insist that they will continue to assess at each meeting, and a month's data or market turmoil will not overly change their minds. San Francisco Fed President Daly said the Fed is "prepared to take the necessary measures when the economic need is clear."

Part of the reason for the recession talk is the unemployment rate in last week's non-farm data triggering the so-called "Sahm Rule," which assumes that if the 3-month average unemployment rate rises by 0.5 percentage points from the 12-month low, it usually signals a recession. However, even the author of this rule, former Fed economist Claudia Sahm, downplayed the latest triggering factor as pandemic and weather-related seasonal factors continue to plague employment data.

The U.S. economy is currently slowing to a more sustainable level, and a near-term economic recession is not the most likely path. However, with a weak labor market, the Fed still seems poised to cut rates in September - a move that will also be accompanied by policymakers releasing the latest quarterly forecasts, including the long-term neutral rate.

JPMorgan strategist Kristina Cooper believes: "The Fed's decision not to cut rates last week was a mistake, but I don't think this will cause irreparable damage to the economy. The stock market sell-off is a very emotional market reaction, overestimating the likelihood of an economic recession."