Wall Street’s growing anticipation for the Federal Reserve to cut interest rates intensified this week, fueled by extreme volatility that has rattled financial markets and revived fears of economic contagion and a potential recession. However, as the dust begins to settle, a new concern has surfaced: Investors who are betting on the Fed to make significant rate cuts could be setting themselves up for disappointment—or worse, walking into a market trap.
Earlier this week, the possibility of an interim rate cut before the Federal Reserve’s scheduled policy meeting on September 17-18 was a hot topic of discussion on Wall Street. This speculation was driven by a combination of market volatility, weak economic data, and growing concerns about the stability of the economy. However, as the week progressed, this expectation began to cool off, particularly after the release of Thursday’s jobless-claims report. The data showed that fewer Americans applied for unemployment benefits than expected, which reduced the likelihood of an immediate rate cut. Diane Jaffee, a senior portfolio manager at TCW, commented that the jobless-claims data makes the prospect of an interim rate cut less likely, indicating that the Fed is in no hurry to take drastic action.
The jobless-claims report also provided some relief to the markets, which had been on edge following a weak jobs report for July. The disappointing jobs data had revived fears of an impending recession and fueled discussions about the possibility of more aggressive rate cuts. Investors were concerned that the Fed may have kept interest rates too high for too long, potentially sowing the seeds of a recession. However, with the latest jobless claims showing some resilience in the labor market, the immediate pressure on the Fed to act has diminished.
Looking ahead to September, Jaffee believes that it is the most likely time for the Fed to begin cutting rates. While there is a possibility of a more substantial cut of 50 basis points, TCW’s base case remains a 25-basis-point reduction. Jaffee emphasized that the Fed will be cautious in its approach, aiming to make the right decision rather than rushing into a move that could have unintended consequences.
The fervor for rate cuts has been building among investors, especially after the U.S. unemployment rate hit a three-year high of 4.3% in July. This increase in unemployment triggered the Sahm rule, a recession indicator that signals economic downturns based on labor market conditions. The unemployment data, combined with concerns over the state of the global economy, has led to heightened anxiety among investors.
Adding to the market turmoil was the abrupt unwinding of the popular Japanese yen “carry trade” earlier in the week. This event sent shockwaves through global financial markets, leading to significant volatility. The S&P 500 index experienced its worst daily drop in nearly two years as Treasury yields plummeted and investors scrambled to find safe-haven assets. The Cboe Volatility Index, commonly known as Wall Street’s “fear gauge,” surged to elevated levels, reflecting the heightened anxiety in the markets.
As the week progressed, volatility began to ease, and stocks started to narrow their weekly losses. Analysts at J.P. Morgan estimated that the global carry trade had already unwound by about three-quarters, indicating that the worst of the market turmoil may be behind us. However, Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management Co., cautioned that the labor market is showing signs of weakness, which could lead to further volatility in the markets. He advised investors to be prepared for the risks they are taking, particularly in case the U.S. economy slips into a recession.
Thursday’s rebound in stocks provided some relief, with the Dow Jones Industrial Average and the S&P 500 narrowing their weekly losses to 0.8% and 0.6%, respectively. The Nasdaq Composite, meanwhile, was down 0.8% for the week. Despite these losses, the S&P 500 remains up 11.4% for the year, thanks to a strong rally in the first half of 2024.
Even with the recent market jitters, traders have been increasingly betting on the Fed cutting rates by 50 basis points in September. The odds of such a move have risen to nearly 60% as of Thursday, up from less than 5% a month ago, according to the CME FedWatch Tool. If this scenario plays out, the federal funds rate would be reduced to a range of 4.75% to 5%. This growing expectation for rate cuts reflects the market’s belief that the Fed will need to take action to prevent a recession.
The Fed has maintained its policy rate at a 20-year high of 5.25% to 5.5% for more than a year, managing to avoid triggering a recession thus far. However, short-term rates suggest that recession-style rate cuts are already priced in, according to researchers at Société Générale. Recent short-term rates have begun to reflect expectations of more than 1% in rate cuts over the next six months, a threshold that has historically indicated the likelihood of a recession.
Jitesh Kumar, an equity-derivatives strategist at Société Générale, warned in a client note that traders seem to be anticipating a downturn, and if economic data fails to meet these expectations, the markets could experience another bout of volatility. He cautioned that Wall Street may have once again gotten ahead of itself in predicting aggressive rate cuts.
Reflecting on past experiences, Brent Schutte of Northwestern Mutual advised investors to consider the risks involved in betting on rate cuts as a “magic elixir” for the economy. While lower rates can provide a boost during economic downturns, they are not a cure-all, especially if the economy is already showing signs of weakness. Schutte urged investors to prepare for the unexpected and to consider diversifying into less popular areas of the market, which might offer better protection in uncertain times.
As the debate over the Fed’s next move continues, investors are left to navigate a complex landscape where the potential for further volatility remains high. While some investors are hopeful that rate cuts will bolster the economy, others are wary that such expectations might lead to yet another market trap if the Fed’s actions don’t align with the market’s hopes. In this uncertain environment, investors must weigh their options carefully and prepare for the possibility of further turbulence in the markets.