It looks like buyers may have bet too soon when they thought the Federal Reserve would cut interest rates quickly between now and the end of next year.
Traders are expecting 175 basis points of cuts over the next 18 months, which is the most since early March, according to an email from Jim Reid of Deutsche Bank.
Reid said that the only time the central bank has cut interest rates that much was when the U.S. economy was shrinking. One time was in the mid-1980s, when real rates were still very high.
Between now and the end of next year, a recession isn’t impossible, but new figures show that the economy and job market have only slowed down slightly so far.
Instead of traders smelling a slump, Reid thinks the most likely reason is that they are once again showing what he called a “inbuilt dovish rates bias.” As Reid points out, this would be the eighth time since the Fed began raising interest rates in March 2022 that traders have bet on big cuts only to see those predictions come true.
Reid also talked about two possible outcomes in which the Federal Reserve could lower interest rates seven times over the next 18 months.
The first is that the U.S. economy does shrink from now until the end of 2025. The other reason is that the economy has changed since the pandemic, so the central bank can boldly lower interest rates when there isn’t a recession going on without risking a return of inflation. The second option would be “the perfect soft landing,” and Reid thinks it is not likely to happen, even though it is technically possible.
Investors are hoping that Fed Chair Jerome Powell will give them more information about the central bank’s plans to cut interest rates later this week. Traders think that the market will almost certainly start in September.
What Powell says about whether or not a rate cut in September is really coming could have big effects on the markets. This month, investors have moved their money from megacaps and semiconductors to small-caps. This is thought to be because of renewed hopes for rate cuts after a June inflation report that was lower than expected.
As of July 28, the iShares Russell 2000 ETF (IWM 0.19%) is up 11.7% and the S&P MidCap 400 ETF (MID 0.49%) is up 10.6%. According to FactSet, the tech-heavy Nasdaq Composite COMP 0.49% has dropped 2.1% in the same time frame.
