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Investors have significantly increased their expectations for a half-percentage-point interest rate cut by the Federal Reserve (the Fed) next week, as the US central bank prepares to reduce borrowing costs for the first time in over four years.
Traders in swaps markets are currently pricing in a 49% chance that the Fed will opt for a substantial cut to avert economic damage caused by high rates. On Thursday, the probability was only 15%.
This reassessment propelled stocks higher on Friday, leading the S&P 500 and the Nasdaq Composite to their largest weekly gains this year, with increases of 4% and 6%, respectively.
Mark Dowding, chief investment officer at RBC BlueBay Asset Management, remarked that a half-point cut is now “very much in play” after being “almost entirely priced out” on Thursday.
Markets still attribute a 51% probability to a smaller quarter-point cut, but the likelihood has decreased significantly from Thursday.
The Financial Times and the Wall Street Journal reported on Thursday evening that the Fed faces a close decision between a half-point and a quarter-point cut.
Former New York Fed president Bill Dudley expressed on Friday that he sees a “strong case” for a half-percentage point cut next week, highlighting the growth-restrictive impact of the current rate of 5.25% to 5.5%, which is a 23-year high.
The Fed usually makes adjustments in quarter-point increments, but a 0.5 percentage point cut could act as a pre-emptive measure if officials fear the economy might decelerate too rapidly.
Some officials considered it “plausible” for the Fed to have reduced rates at its last meeting in July, meeting minutes revealed, suggesting that a larger cut could help the central bank catch up, given that inflation has since decreased further.
“The path of least regrets for the Fed is to lead with 50 [basis points],” stated Tim Duy, chief US economist at SGH Macro Advisors. “It’s the only logical policy choice.”
Gabriele Foà, a fund manager at Algebris Investments, noted that the Fed is “better off frontloading cuts” rather than risking “falling behind the curve in a downturn.”
Wednesday’s Fed meeting, the last one before November’s presidential election between Kamala Harris and Donald Trump, is highly significant as officials strive to steer the world’s largest economy towards a “soft landing” where inflation is controlled without causing a recession.
A closely watched survey from the University of Michigan indicated that consumer expectations of inflation over the next year had dropped to 2.7%, the lowest rate since late 2020. The university’s Friday report also showed consumer sentiment for September rose to a four-month high.
The yield on two-year US Treasury bonds, which reflects interest rate expectations and moves inversely to prices, fell 0.06 percentage points to 3.59% on Friday.
Analysts have described the upcoming meeting as one of the most uncertain in years, following recent data presenting a mixed picture of an economy with some residual price pressures alongside weakness in the labor market.
Recent figures showed headline inflation falling to 2.5% — near the Fed’s 2% target — but core inflation rose more than anticipated by 0.3% month-on-month, partly due to pressures in the housing market.
“If you’ve got lingering inflation in the housing and shelter sector, a 50 basis point cut could potentially actually accelerate or amplify that,” stated Wylie Tollette, chief investment officer at Franklin Templeton Investment Solutions, who anticipates a quarter-point cut.
He added that the upcoming election could further complicate the case for a significant cut.
Trump has suggested that a Fed rate cut would benefit Harris as the incumbent vice-president, “even though it’s something that they know they shouldn’t be doing.”
Tollette further noted, “The Fed’s goal is to do what’s right for the economy, but they do not want to be perceived as benefiting the incumbent candidate by cutting aggressively.”
However, with rising unemployment and slowing demand, Fed officials aim to prevent further weakening of the labor market.
Fed Chair Jay Powell stated last month that the central bank would “do everything we can to support a strong labor market as we make further progress towards price stability.”
Salman Ahmed, global head of macro at Fidelity International, commented, “It’s a cat-and-mouse game. We have started the cutting cycle, but a lot about it remains to be determined.”
He added that for most of the post-pandemic cycle, it has become “abundantly clear that neither the market nor the Fed has any idea what the Fed will do.”
Last December, Fed forecasts signaled 0.75 percentage points of cuts during 2024, but by June it suggested it would only implement one quarter-point cut for the year.
Additional reporting by Kate Duguid and Laurence Fletcher