Rate cut bets are out of touch with the economy? The Fed may take its time

Investors expect the Federal Reserve to cut interest rates by about 240 basis points by the end of next year, equivalent to lowering the federal funds rate from the current range of 5.25%-5.5% to nearly 3%. Torsten Slok, Chief Economist at Apollo Global Management, said that such a rate cut pace would signal an economic recession.

Slok stated in a report on Tuesday, "Despite surveys showing that the market generally expects an economic soft landing, the interest rate market is pricing in a comprehensive recession."

Due to the expected rate cuts, the yield on the two-year U.S. Treasury note has dropped by about 140 basis points from its peak in April 2024, closing at 3.61% on Tuesday, indicating that the bond market expects the average rate for the next two years to reach this level.

"The bond market has already priced in a significant amount of rate cuts from now until next year, which is a very aggressive scenario," said John Madziyire, Head of U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS) at Vanguard. "To achieve this goal, we need to see a significant slowdown in the economy."

Wei Li, Global Chief Investment Strategist at BlackRock Investment Institute, believes that as the market prices in sustained inflationary pressures, short-term U.S. Treasury yields will rebound.

"The market has actively digested a series of rate cuts by the Federal Reserve. Such a rate cut pace usually only occurs in response to an economic recession, but recent data indicates more of an economic slowdown than a recession," Li said. "We believe the Fed will not cut rates significantly or rapidly."

Ed Al-Hussainy, Senior Interest Rate Strategist at Columbia Threadneedle, stated that healthy corporate profits and a stable labor market do not seem to justify the market's expectation of a significant rate cut.

Hussainy believes that there is a disconnect between market expectations and the health of the economy. He pointed out, "Corporate default rates are very low, profit growth is very healthy, all of which are related to the labor market and overall growth."

Investors say that a shallower rate cut cycle will be similar to the 1990s when, despite economic growth, inflation remained a concern for the Fed due to a strong job market.

In contrast, in the deeper rate cut cycles of 2007 and 2008, the Fed aggressively cut rates to address economic slowdown and the eventual financial crisis.

The repricing of the market's outlook on Fed rate cuts may not necessarily spell doom for investors.

The futures market generally expects the Fed to start cutting rates in the spring of 2024. While these rate cuts have not materialized, the S&P 500 index continues to rise, led by large-cap tech stocks related to artificial intelligence.

Vishal Khanduja, Co-Head of Broad Market Fixed Income at Morgan Stanley Investment Management, said, "We are quite confident... economic growth is slowing down, and the anti-inflation trend remains intact ”