CPI becomes the last hope for the Fed's first 50 basis point cut? This may not be a good thing!

In terms of factors influencing the path of US interest rates, the influence of inflation data has receded behind employment data, but this week it has once again become a top priority for financial market participants.

The August Consumer Price Index (CPI) released on Wednesday may ultimately become a decisive factor in whether the Federal Reserve will make a significant 50 basis point rate cut at the September policy meeting. Since the end of 2008, the Federal Reserve has never lowered borrowing costs by this much at once, when the United States was in the midst of the most severe financial crisis since the Great Depression.

Currently, one of the biggest issues investors face is whether this Wednesday's inflation data, if it clears the way for a 50 basis point rate cut by the Federal Reserve in less than two weeks, will be seen as good news or bad news.

Friday's data showed an addition of 142,000 new jobs last month, below expectations, reinforcing the view that the labor market is slowing down. The report, along with downward revisions to job growth in July and June, has made investors uneasy and has not fully addressed the question of how much the Fed might cut rates in September.

Economists at Wells Fargo wrote in a report last Friday, "The August jobs report has little impact on the debate over whether to cut rates by 25 basis points or 50 basis points this month. We stick to the expectation of a 50 basis point rate cut, but acknowledge the real possibility of a 25 basis point cut."

Meanwhile, concerns about the extent of the slowdown in the US economy beyond expectations led to a sell-off in US stocks last Friday, marking the worst start to September in over a decade. Short-term US Treasury yields plummeted, with the benchmark 10-year Treasury yield closing above the 2-year Treasury yield for the first time since July 1, 2022.

Jay Hatfield, CEO of Infrastructure Capital Advisors, based in New York and managing around $2.2 billion in assets, said that Friday's employment data ruled out the possibility of a 50 basis point rate cut by the Fed in September, as the addition of 142,000 jobs and a 4.2% unemployment rate still align with normal economic growth.

However, Hatfield added, "If the Fed really cuts rates by 50 basis points this month, 'it means we are definitely heading into a recession,' because policymakers have always lagged behind the curve and have consistently adhered to a cautious rate-cutting path.

Last Friday, federal funds rate futures fluctuated in both directions as the market was confused about how to interpret comments from Federal Reserve Governor Waller after the data was released. Traders briefly expected a 79% chance of a 50 basis point rate cut by the Fed in September, but then shifted to a 71% chance of a conventional 25 basis point rate cut.

Elyse Ausenbaugh, Head of Investment Strategy at J.P. Morgan Wealth Management in New York, and Emily Roland, Co-Chief Investment Strategist at John Hancock Investment Management, hinted that the August CPI report could be a key determining factor **

Keith Buchanan, a senior portfolio manager at global Investments managing $25 billion in assets, stated that the August CPI report "will confirm or deny the expectation of a 50 basis point rate cut, which would be the largest rate cut in a long time. As inflation declines, interest rates become increasingly restrictive, so cutting the target rate by 50 basis points may not necessarily shift policy to a completely accommodative stance."

Buchanan said in a phone call last Friday, "The key issue is whether a 50 basis point rate cut means that the Fed has gone too far and for too long at interest rates above 5%, with the economy being too weak, thus increasing the likelihood of a recession more than the Fed can accept."

The portfolio manager mentioned that the P/E ratio of US stocks is still around 21 times, meaning that this level does not imply an imminent economic recession, so "the pricing of all financial assets will be influenced by the wording and tone of the Fed's next policy statement." Market participants will be "closely watching" what Fed Chairman Powell says at the post-meeting press conference on September 18, and whether he hints at officials being "concerned about how quickly the economy is softening and prepared to take further action."

Currently, Wall Street expects Wednesday's CPI data to add color to a recent series of positive news on inflation.

Teams at Barclays Bank and Bank of America Securities respectively forecast an overall CPI year-on-year rate of 2.5% and 2.6% for August, with the latter in line with market expectations. This is lower than July's 2.9%. They also expect that after a month-on-month increase of about 0.2% in August, the year-on-year growth rate of core CPI will remain at 3.2%.

Meanwhile, the yield on US Treasury Inflation-Protected Securities (TIPS) has been declining, with these securities often reflecting market sentiment on government borrowing costs, inflation, the economy, and monetary policy.

According to Tradeweb data, the yield on 10-year TIPS hovered around 1.69% last Friday, close to the lowest level since the end of December last year. The yield on 5-year TIPS has also been declining over the past 12 months, to 1.64%.

Investment firm Bay Street Capital Holdings' general partner William Huston in Fremont, California, said he has been in the camp waiting for a rate cut for over a year. "A rate cut is indeed needed," Huston said in a phone call last Friday. "You will see consumers spending less money globally, and businesses reducing investment. Therefore, a 50 basis point rate cut will be welcomed. Wednesday's CPI report is the data highlight for the week."

The yield on 5-year TIPS has fallen below 1.7%