The Fed Cuts Aggressively, but Remains Cautious About Future Cuts

The Federal Reserve has reduced the target range for the federal funds rate by 50 basis points (bps) to 4.75%–5.00%, the first reduction in over four years. This decision, while anticipated, marks a pivotal shift in monetary policy. The Fed also released updated economic projections, which highlighted it expects to reduce interest rates by a total of 200 bps through 2025. That level is less than what the market expects the Fed will cut, according to futures prices, and reflects the balancing act of mitigating inflation risks and supporting a softening labor market.

The Fed is embarking on a rate-cutting cycle after hiking rates by over 500 bps since March 2022. The Fed has been cautious about cutting rates due to inflation concerns and lagged the Bank of England and European Central Bank, which cut rates for the first time this cycle earlier this summer. The Fed’s stance has shifted as inflation and labor market risks have become more balanced. August data showed US headline inflation at 2.5% year-over-year, the lowest reading since February 2021, while US nonfarm payrolls data indicated a softer labor market than previously thought. Given the recent deterioration in the labor market, the Fed opted to start with a less common 50-bp cut, as opposed to a typical 25-bp move.

The initial market response was mixed following the announcement. US equities initially rallied, while Treasury yields and the US dollar fell, but those moves mostly reversed during Fed Chair Jerome Powell’s press conference. This initial market response is unsurprising given the split expectations on whether the Fed would cut by 25 bps or 50 bps. Interest rate traders have priced in 100 bps of cuts in 2024 and another 160 bps in 2025, and recently shifted to slightly favoring a larger 50-bp move to kick off this rate-cutting cycle. Shifts in interest rate expectations has added to equity market volatility recently, leading some investors to move out of crowded positions like the Magnificent 7 and yen/USD carry trade.

While the September 18th decision emphatically sets the course, the future pace and extent of rate cuts are crucial. According to the Fed’s updated summary of economic projections, it expects to cut rates by a total of 200 bps through 2025. That is up from the projected total of 125 bps at its June meeting, but it is below what the market expects over the same period (260 bps) and is well below the average amount of cuts delivered in the first year of the cutting-cycle when there is a recession (320 bps). This reflects the balancing act the Fed is trying to strike as it attempts to normalize policy while simultaneously mitigating inflation risks and supporting a softening labor market. The Fed faces two-way risks: cutting too much, too soon could stoke inflation, while cutting too little, too late could risk a recession. While the Fed has clearly grown more concerned about the labor market, it still appears to be guiding toward a soft landing based on its latest projections.

We believe the US economy is softening but that growth next year will remain positive. This should be positive for risk assets but less so for high-quality bonds. There have been nine rate-cutting cycles since 1984, five of which occurred without a recession. On average, US equities returned 17.1% in the first year following the first cut when this was the case, versus -1.0% when a recession occurred. On the other hand, US Treasury securities usually generate positive returns when the Fed cuts rates, but their upside is limited absent a recession.

As such, we believe investors should maintain equity and high-quality bond allocations in line with policy.

TJ Scavone, Senior Investment Director, Capital Markets Research