Going against the majority! STANCHART insists on expecting a 25 basis point rate cut this week, listing seven major doubts about the 50 basis point expectation

In the U.S. stock market on Tuesday, September 17th, according to the pricing in the federal funds futures market, investors expect the probability of the Fed announcing a 50 basis point rate cut on Wednesday to be over 60%, up from around 30% a week ago. At the same time, the probability of a 25 basis point rate cut is less than 40%.

Although most market participants expect the Fed to start with an extraordinary 50 basis point rate cut, Steve Englander, G10 FX research and North America strategy global head at Standard Chartered Bank, still insists that the Fed will only cut rates by 25 basis points. He stated that based on recent economic data, a 50 basis point rate cut is not likely to become a reality as inflation data does not support a rapid return of inflation to the Fed's target of 2%.

Englander pointed out that recent reports from The Wall Street Journal and the Financial Times suggest that at least some members of the Federal Open Market Committee (FOMC) may have initially considered a 50 basis point rate cut. Some market participants believe that these reports are efforts by FOMC members to reduce the surprise of a 50 basis point cut, but it is currently unclear whether these reports reflect informal comments from Fed officials during the pre-FOMC blackout period.

In a recent report, Englander listed seven reasons supporting a 50 basis point rate cut and refuted them one by one.

Reason 1: The Fed cannot disappoint the asset markets.

According to Englander's report, as of Monday, September 16th, U.S. stocks had fallen 1.5% from their historical highs, but were still up 26.5% year-on-year, and the 10-year U.S. Treasury yield was 25 basis points lower than at the beginning of September. Financial conditions were very loose before the above news reports were released. Even if the Fed signals that a 50 basis point rate cut is "not yet necessary," the asset markets are unlikely to be so fragile and disappointed in this signal in the long term.

Reason 2: The U.S. economy is very fragile, and a 25 basis point rate cut instead of 50 basis points will trigger an economic downturn spiral.

The report states that Standard Chartered is very skeptical that any economic model reflects the characteristics of an economy teetering on the edge of a cliff as implied by the above concerns. Reaching the edge of a cliff requires the outbreak of some economic or market crisis, and the current situation seems quite calm.

Reason 3: The economy is clearly moving towards the 2% inflation target.

The report argues that Standard Chartered opposes the use of the word "clearly" and agrees to use the phrase "most likely," while pointing out that this is only a prediction and current data does not reflect it. Both Standard Chartered and market consensus expect the core PCE in the U.S. to grow by 2.7% year-on-year in August. Standard Chartered believes that this indicator is unlikely to slow significantly in the remaining time this year, especially considering the low monthly inflation rate at the end of last year, making it difficult for the year-on-year inflation growth rate to decline significantly by the end of the year. The Fed's achievement of the inflation target in the final stretch may depend on how low the inflation rate is in the first quarter of next year

Reason 4: Inflation deviating from the target is all due to base effects.

STANCHART believes that base effects are basically irrelevant because they reflect the situation from a year ago, not the current situation. The problem is that there has been a continuous increase in prices in the first quarter for two consecutive years. Therefore, until the data for the first quarter of next year tells us whether the quarter-on-quarter inflation is lower than before, we do not know whether the recent two years of inflation are due to residual seasonal effects or coincidence. Only when the quarter-on-quarter inflation in the first quarter of next year is under control, is it possible to establish a path for inflation to decrease from the current level.

Reason 5: If interest rates are not significantly lowered, the unemployment rate will rise significantly.

STANCHART believes that economic data are still mixed. There is limited evidence of large-scale layoffs. While U.S. economic activity is sluggish, it has not yet reached recession levels. If by the FOMC meeting in November or December, the unemployment rate does indeed rise significantly from the current level, for example, to 4.5%, then a 50 basis point rate cut may be reasonable.

Reason 6: It is more serious to make a mistake of cutting rates by 25 basis points than by 50 basis points.

According to STANCHART's report, they do not agree with most of the risk management discussions in the market. For the Federal Reserve, the question is whether it is a bigger mistake to cut rates by 50 basis points when it should be 25 basis points, or whether it is a bigger mistake to cut by 25 basis points when it should be 25 basis points. STANCHART believes that the Federal Reserve can cut rates by 25 basis points while providing a clear message that the FOMC will closely monitor the conditions for a 50 basis point rate cut. If the unemployment rate rises to 4.5% in September, the market will be prepared for a 50 basis point rate cut. If the unemployment rate continues to rise in October and November, there may be further cuts of 50 basis points. The market will be prepared, and the expectation of a 50 basis point rate cut will be reflected in the stock and bond markets before actual action is taken.

Starting a rate cut cycle with a 50 basis point cut may exacerbate the market's overpricing of loose policies. If the unemployment rate remains below 4% and core PCE growth remains steady, there will be more market turmoil afterwards. After starting with a 50 basis point cut, regardless of the statements from the FOMC and Fed Chair Powell, the market is likely to view this magnitude of rate cut as the norm. Guiding the market to judge whether a 50 basis point cut, a 25 basis point cut, or a pause in cutting rates will be very difficult. STANCHART believes that compared to accelerating rate hikes after an initial 25 basis point increase, slowing down the pace after starting with a 50 basis point cut may bring much greater market uncertainty.

Reason 7: Real interest rates are too high and must be lowered immediately.

STANCHART notes that Powell has stated that he relies on data and is skeptical of immeasurable factors. Under the most favorable conditions, the sample measurement accuracy of the equilibrium real interest rate is low, and the real-time measurement accuracy is extremely low. Not long ago, there was a heated discussion in the market about the limited impact of real interest rates on economic activity. Whether the real interest rate is at a neutral level or more than 50 basis points above it may be important over a 5-10 year period, but STANCHART believes that this deviation is unlikely to have an impact on quarter-on-quarter comparisons, and even has little impact on year-on-year GDP. If the Federal Reserve is still uncertain about the downward trend of inflation in the final mile, advocating for real interest rates can only be ranked second or third Englander also listed two major risks of a 50 basis point rate cut. First, the Federal Reserve's forecast may be wrong. The median forecast of interest rates by FOMC policymakers announced in June this year showed that the Fed's policymakers have lowered their forecast of three rate cuts this year to one. The Fed's goal is to send a clear signal of policy direction in the medium term. If expectations for inflation and unemployment are proven to be wrong, the Fed will be in a policy-making state similar to the stop-and-go policies of the 1970s.

Second, some may interpret a 50 basis point rate cut in September as an action influenced by political factors. For example, Trump is likely to interpret a significant rate cut as the Fed secretly supporting the Democratic Party to boost confidence and asset markets. From the Fed's own perspective, it should not make decisions before the election that could be seen as favorable to one party, as this would raise questions about the Fed's independence from political influence