The Fed makes a statement and cuts by 50bps

The market was right, economists were mostly wrong. The Federal Reserve started their rate-cutting cycle with a bang and cut rates by 50bps. However, there was more drama to come. The Fed has also revised down their expectations for interest rates in the short to medium term, while marginally revising higher their longer-term outlook for interest rates.

The Fed sparks the next leg of the risk rally

Combined, a big rate cut and a dovish assessment of future rate cuts, has sent the dollar on a downward spiral, the gold price has hit a fresh record high and stocks initially spiked higher, especially the US mid-cap index. This is good news for the value trade in the US, as this move is supportive of economic growth, and it could prolong the economic cycle. The prospect of further rate cuts from the Fed could see the equal weighted S&P 500 continue to outperform the market-cap weighted S&P 500 in the medium term. The market-cap weighted S&P 500 rose to a fresh record high today, as did the S&P 500 minus the magnificent 7. Interestingly, Microsoft, the world’s second largest company, is currently lower on the day, suggesting that the biggest tech firms will not be leading US stocks higher in the next leg of this stock market rally.

The Fed pledges to support the soft landing

The Fed statement was illuminating because the even though the Fed made a large interest rate cut, the first line of the FOMC statement read ‘Recent indicators suggest that the US economy has continued to expand at a solid pace.’ This supports the view that the Fed decided to cut interest rates by 50bps as a precautionary move, to protect the US economy from a potential future recession. The FOMC voted 11-1 to cut rates by 50 bps, with one member preferring to cut by a more moderate 25bps. This suggests that the doves have control at the Federal Reserve, and this may drive policy down the line.

The Fed moves away from data-watching

The Fed is committed to maintaining economic strength and is focused on maintaining stable employment levels at the same time as US economic growth remains moderate. The Fed’s statement said that future rate decisions will depend on ‘incoming information for the economic outlook’, thus, the Fed has moved beyond data dependency, and the economic outlook is key for the future direction of US interest rates. Jerome Powell said that he would not pre-commit to rate cuts in advance, and the FOMC would make decisions on a meeting-by-meeting basis.

FOMC expectations

The FOMC’s projections for future growth, employment and inflation supports the Fed’s reduction in short- and medium-term interest rate expectations. The Fed now expects GDP to remain stable at 2% YoY growth between 2024 – 2027. It revised its forecast for the unemployment rate higher in the coming years. The unemployment rate this year was revised upwards to 4.4% from 4.2%. Inflation was revised down a notch, the core PCE inflation rate was revised down to 2.6% from 2.8% in June, the core PCE projection for 2025 was revised down to 2.2% from 2.3%. Inflation is only expected to return to the Fed’s target 2% rate in 2026.

US inflation to remain above target rate

Even though inflation is expected to remain above target for the next two years, the FOMC revised down their expectations for interest rates in the next 3 years. The current FOMC expectations for interest rates this year was revised down to 4.4% from 5.1%, the 2025 expectation is 3.4% down from 4.1% in June, the 2026 estimate for US interest rates is 2.9%, down from 3.1%. The longer-term terminal rate was revised up a notch to 2.9% from 2.8%.

The downgrade to the FOMC’s interest rate expectations suggests that this was not a ‘hawkish’ cut and instead, the FOMC remains committed to its dovish bias and its intense cutting cycle.

Powell would not pre-commit to future rate cuts, and Powell said that he did not think that they were in a rush, and instead they made a ‘good strong start’ because they had confidence that inflation is falling.

The market is expecting too many rate cuts from the Fed this year

The Fed Funds Futures market is still expecting rates to fall 0.4% more this year than the Fed’s latest projections. The Fed expects rates to fall to 4.4%, the market is still expecting rates to fall to 4%. Thus, the market could recalibrate interest rate expectations higher for year end. If this happens, then this meeting could be bearish for bonds. The 2-year bond yield initially fell on the back of the Fed decision; however, it has since reversed part of this move, and 2-year yields are currently down 5 bps on Wednesday evening.

Rate cuts and tapering to happen simultaneously

The Fed will continue to shrink their balance sheet at the same time as they are cutting rates. Powell said that this was not contradictory and that you can do the two things simultaneously, because it’s about normalization. The Fed is simultaneously trying to normalize their balance sheet at the same time as they embark on normalizing interest rates.

The gold price and market fears about inflation

To summarize, the Fed made a bold move by cutting rates by 50bps on Wednesday. This triggered predictable reactions in financial markets. The dollar is broadly lower, stocks are higher, and the gold price made a fresh record high, before hitting decent resistance at $2,600. The gold price reminds us that there are some in the market who think that the Fed is cutting rates before inflation has been stamped out of the US economy. It is worth remembering that Jerome Powell would not pre commit to rate cuts at this meeting, so while the doves are in control at the Fed, nothing is set in stone.

Why the Fed does not change the dial for the BOE

We now move onto tomorrow’s BOE meeting, we don’t think at this stage that the BOE will be pressured into cutting rates by the Fed, since the BOE has a single mandate. The BOE and the ECB focus only on inflation, whereas the Fed can also focus on employment. GBP/USD tested $1.33; however, this level was rejected by the market. If it can get back above this level could depend on the BOE decision on Thursday.