Analysis – Fed’s rate cut cycle may be shallower than expected

Authors: David Randall and Davide Barbuscia

NEW YORK (Reuters) – The U.S. Federal Reserve on Wednesday begins a long-awaited easing cycle, so interest rate cuts in the coming months could be shallower than the market expects.

Some prominent investors and analysts are predicting a cycle of interest rate cuts that could keep rates relatively high as the economy continues to perform well. They argue that deep cuts would only make sense in the event of a looming recession.

“In my view, current market expectations for the Fed to lower interest rates go beyond what most Fed officials and economists agree on,” Mohamed El-Erian, former head of bond asset manager PIMCO, said in an email to Reuters.

Expectations are split between a 50-basis point cut and a 25-basis point cut on Wednesday, with bets tilted toward a bigger cut from Tuesday, setting markets up for an explosion of volatility. In addition to announcing its rate decision, the Fed will update its forecasts for the future path of rate cuts.

In their latest forecasts in June, Federal Reserve officials estimated that the long-term “neutral” interest rate needed to keep inflation under control would be 2.8%.

Investors are pricing in about 240 basis points of rate cuts by the end of next year, which would equate to a rate of almost 3%, from the current 5.25%-5.5%. That pace of rate cuts would signal a recession, according to Torsten Slok, chief economist at Apollo Global Management.

“Despite research indicating consensus is predicting a soft landing, interest rate markets are pricing in a full-blown recession,” Slok said in a note Tuesday.

Two-year Treasury yields have fallen about 140 basis points since their April 2024 peak on expectations of lower rates. At 3.61% on Tuesday, they suggest interest rates will average about the same over the next two years.

“The bond market has priced in a lot of (cuts) between now and next year, which is a very aggressive scenario,” said John Madziyire, head of U.S. Treasuries and TIPS at Vanguard. “We need to see a significant slowdown for that to happen.”

Wei Li, global chief investment strategist at BlackRock Investment Institute, predicts that short-term Treasury yields, which have been moving counter to prices, will start to rebound as the market starts to factor in persistent inflationary pressures.

“Markets have been aggressively pricing in a series of Fed rate cuts, which are typically seen only when the Fed is responding to a recession, even though recent data point to a slowdown rather than a recession,” Li said. “We don’t think the Fed will be able to cut far and fast.”

Strong corporate profits and a stable labor market don’t justify the deep cuts the market is expecting, said Ed Al-Hussainy, senior interest rate strategist at Columbia Threadneedle.

He added that a discrepancy is emerging between the market and the condition of the economy.

“You have very low default rates and very healthy earnings growth, and those are things that correlate with the labor market and overall growth.”

HOW MANY CUTS?

Investors say a shallower rate-cutting cycle would resemble the 1990s, when inflation was still a concern for the Fed because of a strong labor market in a growing economy.

This is in contrast to the deeper cycles in 2007 and 2008, when the Federal Reserve aggressively cut interest rates in response to the economic slowdown and ultimately the financial crisis.

The market’s re-pricing of interest rate cuts does not have to spell doom for investors.

Futures markets began 2024 with high expectations that the Fed would begin cutting interest rates in the spring. While those cuts did not materialize, the S&P 500 continued to rally on the strength of AI-related large-cap tech stocks.

Bonds gained even though the rate-cutting cycle was shallower than previously expected.

“With inflation stubbornly high and economic growth slowing, this could be a challenging environment for the fixed income market,” said Vishal Khanduja, co-head of broad fixed income at Morgan Stanley Investment Management.

“However, we are convinced that the situation is improving and the disinflationary trend is intact,” he added.

(Reporting by David Randall and Davide Barbuscia; editing by Megan Davies and Rod Nickel)