Analysis-After jumbo Fed rate cut, market hopes ride on US soft landing

By Lewis Krauskopf and Davide Barbuscia

NEW YORK (Reuters) - One of the most consequential Federal Reserve meetings in recent history has put investors’ focus squarely on one question: whether the central bank has kicked off its rate cutting cycle in time to keep the economy from slowing too rapidly.

The Fed delivered a 50 basis point rate cut on Wednesday - lowering borrowing costs for the first time in more than four years - and assured investors the jumbo-sized reduction was a measure to safeguard a resilient economy, rather than an emergency response to recent weakness in the labor market. Bets on the size of the rate cut swung in the days before the meeting and were near an even split on Wednesday morning.

The degree to which Powell's outlook pans out is likely to be a key factor in the trajectory of stocks and bonds for the remainder of 2024.

Prospects of a “soft landing,” where the Fed brings down inflation without pushing the economy into recession, have lifted stocks and bonds this year, though signs of a softening labor market have fueled worries that the Fed may be too late in acting to shore up growth.

"Right now, it looks as if the market is going to pause to digest what was to many a surprise,” said Eric Beyrich, co-CIO of investment advisory firm Sound Income Strategies. “There will still be people thinking, ‘wow, If the Fed cuts big like that, what do they see that we’re not seeing that suggests the economy will get worse?’”

Market reaction on Wednesday was relatively subdued as stocks, Treasuries and the dollar retraced initial, post-decision rallies. The S&P 500 ended down 0.3%, after rising as much as 1% during the session. The index is up nearly 18% this year and stands near a record high.

In comments following the decision, Powell called the move a "recalibration" to account for the sharp decline in inflation since last year and said the central bank wanted to stay ahead of any potential weakening in the jobs market.

Some investors were skeptical of that sunny view.

“Despite what Chair Powell is saying in the press conference, a 50 basis point move does indicate that there is concern that they are behind the curve,” said Josh Emanuel, chief investment officer at Wilshire.

Emanuel said he was already overweight bonds coming into the meeting, favoring investment-grade credit over riskier high-yield bonds ahead of an expected deterioration in the economy.

Many others, however, believed the rate cuts were a positive development for the market and would buoy the economy.

"I think that this dramatically increases the odds of the Fed being able to stick the landing, which ultimately will be bullish for risk assets," said Jeff Schulze, head of economic and market strategy at ClearBridge Investments.

Indeed, stocks have performed well following rate cuts - as long as the economy stayed out of recession. The S&P 500 has posted an average 14% gain in the six months following the first reduction of a rate-cutting cycle, when the Fed cut in a non-recessionary period, data from Evercore ISI going back to 1970 showed. That compares to a 4% decline in that period after the initial cut when the economy is in a recession.

Rick Rieder, chief investment officer for global fixed income at BlackRock (NYSE:BLK ), said investors may have overreacted to recent labor markets reports that had come in weaker than expected. Other data, such as gross domestic product growth estimates, continued to show a resilient economy.

"I think the markets got ahead of themselves again in terms of interpreting that data was very soft," he said. "Chair Powell said it's a solid economy, and it is."

LONG-TERM ADJUSTMENTS

Fed officials updated their views on interest rates from their latest June projections, but while they now anticipate deeper cuts, those rate forecasts remained above market expectations of a more accommodative central bank.

The Fed said it expects the Fed funds rate - currently in the 4.75% to 5% range - at 3.4% by the end of next year, while rates traders are betting on about 2.9%. Also, the Fed's endpoint for rate cuts reflected a slight upgrade, to 2.9% from 2.8%.

The outlook gap may have sparked a reversal in Treasury markets, sparking a selloff in longer-term Treasuries on Wednesday. The benchmark 10-year Treasury yield , which moves inversely to bond prices, stands at around 3.73 after touching its lowest level since mid-2023 earlier this week.

"In terms of the pace at which cuts were priced in, I think this is a right reaction," said John Madziyire, head of U.S. Treasuries and TIPS at Vanguard, who was betting on long-term yields moving higher.



Others were looking even further out, with some pointing to the outcome of the U.S. presidential election as potentially complicating the path for rate cuts going forward.

"If trade wars were to ensue under a Trump presidency, that could be negative for fixed income," said Andrzej Skiba, head of U.S. fixed income for RBC Global Asset Management. "That would be inflationary and limit the Fed's ability to cut rates"

Source: Investing.com