The Fed is poised to cut interest rates! Wall Street is becoming restless and uneasy

The Federal Reserve is preparing for its first rate cut since 2020, but the size of the initial cut and the level of rates three months later are still unclear.

Traders expect the Fed to announce a rate cut of 25 basis points or 50 basis points on Thursday, with both possibilities almost equally likely.

Since early August, economic data has shown weakness in the job market, sparking debates on whether the Fed's rate cut is too late, with investors showing a clear "aversion to uncertainty" sentiment. After a mostly calm market for most of the year, both the stock and bond markets have become highly volatile.

Investors are trying to assess whether recent economic data only reflects a return to normal from an overheated economy or early signs of an economic downturn. Analysts say that the stock and bond markets seem to have different views on this issue.

This divergence has led to one of the most closely watched Fed meetings in recent years. Investors will closely watch Fed Chair Powell's comments on the economy at the press conference, as well as the Fed officials' "dot plot" projections of future interest rates.

"In the past month or two, the market has been in a state of tension," said Rick Rieder, Chief Investment Officer of Fixed Income at BlackRock. "The bond market has quickly shifted from optimism to recession expectations."

Interest rate derivatives traders now expect the benchmark rate to fall to around 2.75% by the end of next year, currently at about 5.25%. This would be equivalent to ten rate cuts of 25 basis points each, a measure the Fed may only take in the event of an economic downturn.

Meanwhile, the stock market is showing more optimism. The S&P 500 index has experienced several significant single-day declines in the past six weeks, but each time it has rebounded. The index has risen 18% this year, just 0.7% below its all-time high.

Analysts say that the stock market reflects investors' optimism that the Fed can avoid an economic downturn. Massive gains in tech companies have also supported the indices, with some believing that tech companies have a relatively small impact on the overall economy.

So, which view is correct? Many investors have noted that this situation is similar to the end of last year when the bond market quickly anticipated six rate cuts by the Fed by 2024.

"I think the market tends to go to extremes," Rieder added. "I haven't seen much evidence to suggest that the economy is heading towards a recession, at least not in the short term."

Recent economic data has been mixed. Non-farm payroll numbers for June and July were lower than initially reported, but wage growth improved in August. The unemployment rate has slightly risen but remains at a healthy 4.2%. Layoffs are rare. Data from last week shows that the latest weekly jobless claims are roughly the same as a year ago.

The latest CPI report shows that inflation in August dropped to 2.5%, the fifth consecutive monthly decline and the smallest increase since early 2021. U.S. factory activity has slowed down, indicating weak demand.

Short-term U.S. Treasury yields, reflecting traders' expectations of the benchmark rate trend, have sharply declined since the summer began. The 2-year Treasury yield fell to 3.575% on Friday, the lowest level this year. **

The long-term US Treasury bond yields have also declined, with the 10-year Treasury bond yield at 3.648%, down more than one percentage point from the peak in April. As bond yields fall as prices rise, nervous investors are flocking to ultra-safe US Treasury bonds, leading to a decrease in yields.

"The bond market seems to be signaling more rate cuts than we expected, while we anticipate the economy to achieve a soft landing, with a GDP growth rate of 2%," said Alicia Levine, BNY Wealth's head of investment strategy and equities. "I believe that the bond market often overestimates the number of rate cuts, and then as data shows that the situation is not as expected, it will retract expectations."

While few on Wall Street are predicting an imminent economic recession, most agree that the risk of an economic downturn is higher now than it was a few months ago.

"In particular, low-income consumers are showing signs of pressure, with increasing credit card and auto loan delinquency rates." While the largest publicly traded companies are largely unaffected by high interest rates due to their large cash reserves, more debt-dependent small businesses are feeling the pressure of high interest expenses.

David Kelly, Global Chief Strategist at Morgan Asset Management, said that the significant rate cuts predicted by the futures market reflect this additional risk. He said:

"I think there are two possible outcomes here: the economy achieves a soft landing, and the Fed can slowly cut rates as planned. Or, there is also a 30% chance that everything goes terribly wrong, we fall into a recession, the Fed panics, and cuts rates significantly. I believe the futures market reflects a weighted average of these two views."