Signs of easing inflation are giving the Federal Reserve permission to do something investors have been waiting all year: cut interest rates for the first time since the most aggressive rate hike cycle in the past 40 years began in March 2022.

Federal Reserve Chairman Jerome Powell now faces the seemingly impossible task of achieving a decisive victory without pushing the world's largest economy into recession, or at least avoiding a deep and long slump.

Investors face a lot of risk after U.S. stocks surged to record closing highs over the past week. The S&P 500 and Nasdaq Composite hit their 37th and 27th closing highs of the year, at 5,633.91 and 18,647.45, respectively, on Wednesday after Powell testified before Congress in which he appeared to move closer to a rate cut.

Powell reiterated his view that policymakers, whose mission is to promote maximum employment and stable prices, are facing a complex situation: Cutting rates too little or too late could undermine economic activity, but cutting rates too much or too early could hurt progress on inflation.

All three major U.S. stock indexes rose last week as markets see an increased chance that the Federal Reserve will cut interest rates as early as September, though both the S&P 500 and Nasdaq closed Friday below Wednesday's record levels.

“It could be about a hard landing where we could see higher unemployment, lower consumer spending, more layoffs and potentially a bear market, meaning a recession in earnings and the economy,” said Eric Sterner, chief investment officer at Apollo Wealth Management.

Sterner added, “Nevertheless, my base case is for a soft landing as both small and large companies are optimistic about their earnings outlook for this year and next, with all 11 sectors of the S&P 500 likely to report positive earnings growth in the fourth quarter, something that has not happened so far in 2021.”

The Fed's mid-1990s cycle of rate hikes and subsequent cuts provides Powell with a blueprint for how to achieve a soft landing, although some strategists have expressed concerns about the extent of any recession.

In 1994, under the leadership of then-Fed Chairman Alan Greenspan, the Fed raised interest rates by 2.5 percentage points from 3% to 5.5% to cool the heating labor market and control inflation.

John Velis, a strategist at Bank of New York Mellon, said this is the first and only time in decades that policymakers have been able to curb inflation without triggering a recession.

After another 50 basis point increase in early 1995, which brought the federal funds rate to 6%, Fed officials cut rates by 25 basis points in July 1995, December 1995, and January 1996 to prevent any possible recession. They did this even though the S&P 500 was rising at the time.

Until March 2001, a year after the dot-com bubble began to burst, the U.S. economy was in expansion mode, having successfully weathered multiple rate hikes and cuts by the Federal Reserve between 1997 and 2000, as well as the Asian financial crisis in 1997, Russian turmoil that led to the devaluation of the ruble the following year, and the collapse of a hedge fund called Long-Term Capital Management (LTCM).

“Walking the tightrope between avoiding a recession and curbing inflation is difficult,” said Lawrence Gillum, fixed-income strategist at broker-dealer LPL Financial in Charlotte, North Carolina. “There will be adverse outcomes, but you have to say ‘So far, so good.’ You might say a soft landing, or perfect disinflation, is already priced in. In any other scenario, whether it’s a hard landing or a recession, risk assets could be in for a sudden awakening.”

The federal funds rate has remained between 5.25% and 5.5% over the past year, high enough to start having an impact on the economy, as evidenced by weak first-quarter GDP growth, downward revisions to job growth and cooling CPI data for June. A batch of economic data scheduled for release this week includes the June U.S. retail sales report on Tuesday, which will provide clues about the performance of the U.S. consumer.

Gillum said on the call, "Right now, there is a big risk of cutting rates too late. Even so, rate cuts are 'absolutely' a risk to the stock market because they could eventually spark inflation again. Our view is that there is still sticky inflation in the United States and it will take some time to get back to the Fed's 2% inflation target. I have been telling clients that trying to price in three rate cuts from the Fed this year is unrealistic. We expect the Fed to cut interest rates twice this year."

At the beginning of this year, Fed funds futures traders expected the Fed to cut interest rates six to seven times in 2024, but later lowered those expectations. Now, they believe that by June next year, the Fed has a high probability of 5-6 cuts of 25 basis points each, with the first rate cut coming in two months. Meanwhile, San Francisco Fed President Mary Daly said after the release of last Thursday's CPI data that she now supports rate cuts.

Sterner initially believed that the U.S. needed a recession to cure inflation, but he has now changed his mind. He said:

“What’s different about this cycle from the past is that consumers have continued to spend amid high inflation because they have built up huge savings during the pandemic; fiscal stimulus has boosted government spending; and private credit funds have stepped in to provide loans to keep mid-sized businesses afloat.”

Article forwarded from: Jinshi Data