Federal Reserve has begun to move towards another cycle of rate cuts. Last time, the benchmark rate of interest was cut was December 2024.
In Jackson Hole, after two years of aggressive inflation-fighting with hikes to the price of goods and services, Jerome Powell said that “the balance of risks is changing”.
The inflation risks remain, but the job market has weakened.
Investors bet heavily on the Fed’s decision to act in September. The major banks and brokerages have also adjusted their bets.
Should everyone be so bullish about rate reductions? The past suggests that yes. But this time, things are very different.
What is the current policy?
The Federal Funds Rate is now at 4,25-4,50 percent. This represents a drop of approximately 1 full percentage point from the peak reached in Q3 2020.
Two Fed Governors voted against a rate cut at the meeting in July, marking the first time that they had openly voted this way during this cycle.
The minutes of that meeting describe the policy as moderately restrictive, with officials considering the tug-of war between price pressures driven by tariffs and increasing risks for employment.
Powell’s Jackson Hole address was an important confirmation for investors.
The language used by the Chairman suggested that the Committee was easing up, but the pace will be determined by the data received.
Futures markets have a 85% chance of seeing a cut in the Fed rate by 25 basis points. By year’s end, they will likely be pricing about 50 basis points.
Goldman Sachs JPMorgan Barclays, and Deutsche Bank all revised their predictions to anticipate a move in September.
Morgan Stanley has joined the list of bullish forecasters, predicting two cuts in the rate by 25 points for 2025. The long-term projection is 2.75-3.0%.
Data that influenced the Fed
The headline CPI for July was 2.7% and the core CPI 3.1%.
Tarife are driving up the price of goods, while services inflation is still cooling. In June, the Fed’s preferred PCE measure was 2.8%.
On August 29, the July reading is released. This is important for verifying whether or not disinflation has been maintained.
Fed has focused its attention on the labour market. In July, the number of employees grew by just 73,000. Previous months’ figures were revised downwards.
Job openings dropped to 7,4 million, and the unemployment rate increased to 4,2%.
There is a concentration of softness outside the healthcare sector, indicating broader weakness.
Powell acknowledged explicitly in Jackson Hole, that the downside risks of jobs have increased. This is a subtle yet important shift in tone.
The inflation rate is relatively low, but the job market has weakened.
The Fed does not promise a set of meetings. The Fed is preparing to ease and proceed with caution, one meeting at a time.
Since he was appointed chairman of the Federal Reserve, Jerome Powell has followed this playbook.
What the markets read
The bond markets will be the first to react. After Powell’s remarks, 2Y Treasury yields dropped as if pricing in September cuts.
The futures market indicates that the economy will ease by around half of one percentage point this year. This is in line with. view.
The equity markets interpreted this pivot positively. The small and midcap stocks have started to perform better, as they are more susceptible to changes in financing costs and the yield curve.
Now, the risk is not so much about speed as it is about direction.
The Fed may decide to hold the rate in September if the PCE is hot, or if August’s jobs are rebounding sharply.
If that happens, the front-end yields will retrace upward, and stocks could lose their momentum.
If, on the other hand, unemployment rises above 4.5%, or payrolls are negative, then it is possible that Fed will be forced to make larger and faster cuts.
This would be a positive for Treasuries, but it would also likely bring with it equity volatility and higher credit spreads.
The markets are pricing the “base case”, which is an additional September “fine tuning” cut with the possibility of a second in December.
From there, the scenario tree will branch out.
History of cuts
The history of the markets shows that they behave differently depending upon whether or not cuts are based on insurance, recessions, etc.
The S&P 500 index has gained an average of 6-16% per year since 1970 in the years following its first cut.
Equities have returned to a level of 18% in cycles when cuts are made but there is no recession.
The average rate of return fell to around 5% when the economy had already entered a recession.
Reuters research shows that S&P 500 usually declines before rate reductions.
In the first year following a cut, small caps tend to outperform large caps. This is due to their higher sensitivity towards borrowing costs.
The curve of yield usually becomes steeper. The yield curve steepens when front-end yields drop faster than the long yields.
When growth is strong, this tends to be supportive of financials and other cyclicals. Long-duration Treasuries are the best performers in recessions, while equities suffer and credit spreads increase.
Averages hide the spread. It is important to determine whether or not the September reduction is an act of insurance, or the beginning of a new recession cycle.
The importance of the upcoming key macro data cannot be overstated.
Why investors need to be on the lookout for certain trends
It’s simple. Keep an eye on the core PCE to see if tariffs have a lasting impact.
Payrolls, revisions, and unemployment rates are all good indicators of problems in the labour market.
Powell uses the phrase “balanced risk” in his speeches and minutes.
FedWatch Probabilities can be used as a gauge to determine if cuts have already been fully priced.
Investors should be expecting a positive backdrop if the Fed makes a small adjustment to its rate while growth is still intact.
The small and midcaps are likely to lead. Breadth is expected to improve and the investment grade credit carrier remains attractive.
Equities may grind down if data accelerate again and the Fed decides to remain on hold. However, leadership will shift back towards quality growth.
The defensive recession template is applicable if labour contracts sharply: Treasuries are long, high-quality equities and credit of higher grade outperform.
It is almost time for the Fed to pivot. The Fed’s pivot is near.
The history of markets shows that they can recover strongly following insurance reductions.
History also shows, however, that if cuts are made too late they can lead to volatility instead of relief.
Now, investors must decide which side of the history will this cycle follow.
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