UBS economists on Monday reiterated their outlook for a soft landing for the U.S. economy, and the bank firmly expects the Federal Reserve to start cutting interest rates in September. They also believe that the market may have misjudged the extent of the Fed's future rate cuts.

UBS pointed out that although economic data has shown abnormal fluctuations since the outbreak of the epidemic, some trends now seem to have been established more firmly. The U.S. labor market, which was severely overheated two years ago, has gradually returned to a state close to that before the epidemic, driven by strong growth in the labor supply. In addition, retail sales and inflation have also shown signs of slowing down. In May, the core CPI, which excludes food and energy prices, rose by only 0.16% month-on-month, the smallest increase since August 2021. Although the core inflation rate has shown a downward trend year-on-year, its value is still much higher than the pre-epidemic level.

 

“Housing inflation in particular has been more robust than we expected, but we remain confident that a moderation is inevitable in the coming months as new rental information is reflected,” UBS economists wrote. “We maintain our baseline forecast that the Fed will cut rates in September as it responds to weaker growth, labor market, and inflation data. While we acknowledge the risk that the Fed may keep rates on hold longer than our baseline forecast, we still view further rate hikes as unlikely.”

 

UBS emphasized that based on these trends, the U.S. economy seems to be on track for a soft landing, and the Federal Reserve can choose to significantly cut interest rates when necessary to alleviate the risk of economic downturn. The bank also pointed out in a report that although there is still much controversy about the timing of the Fed's first interest rate cut, the end of the easing cycle is more significant for investors.

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UBS believes that despite the changing expectations of the Fed's actions, the stock market has shown strong resilience. After the market's expectations for the Fed's interest rate cuts were significantly reduced, the S&P 500 index has continued to perform strongly this year, which fully highlights the role played by solid economic fundamentals. UBS also said: "Whether the first Fed rate cut occurs in September or December, it may not make a substantial difference."

 

UBS is focusing on the market-implied neutral policy rate, which will be reflected in the 10-year Treasury yield. They believe that the Fed's upcoming Jackson Hole Economic Policy Symposium may bring more stringent scrutiny to the restrictiveness of current policies. Recent economic data, including consumer confidence, job openings and inflation data, have shown that the economy is gradually weakening, prompting UBS to believe that "the weakness in these data is likely to continue in the coming months, which is enough to justify the Fed's interest rate cuts." They expect the Fed to cut interest rates more than the market currently expects, citing the Fed's expected long-term interest rate of 2.75%, which is a large gap from the market's expectation of around 4%.

 

UBS concluded: "Overall, we believe that the market underestimates the number of rate cuts the Fed may make during this cycle." The Fed kept its policy rate unchanged at its June meeting, and the updated median dot plot forecast shows that the Fed will only cut interest rates once by the end of the year, by 25 basis points, which is less than the three times predicted in March, which has led some to worry that the Fed may keep interest rates unchanged until December.


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