The Federal Reserve is preparing to cut interest rates for the first time since 2020, but the size of the first round of cuts and where rates will be in three months are unclear.

Traders expect the Fed to announce a rate cut of either 25 basis points or 50 basis points on Thursday, with both being almost equally likely.

Investors’ aversion to uncertainty has become apparent since early August, when economic data pointed to a weak job market and sparked a debate over whether the Federal Reserve was too late to cut interest rates. After being quiet for much of the year, stocks and bonds have become volatile.

Investors are trying to decide whether recent economic data simply reflects a return to normalcy from an overheated economy or early signs of a recession, and analysts say stocks and bonds appear to have different views on the question.

The divide creates one of the most closely watched Fed meetings in recent years. Investors will be closely watching Chairman Jerome Powell’s comments on the economy at a news conference, as well as the “dot plot” of Fed officials’ projections for future interest rates.

“The market has been on edge over the last month or two,” said Rick Rieder, chief investment officer of fixed income at BlackRock. “The bond market has moved very quickly from optimism to recession expectations.”

Interest rate derivatives traders now expect the benchmark rate to fall to about 2.75% by the end of next year from about 5.25% now. That would be equivalent to 10 25 basis point rate cuts, something the Fed would likely only do in the event of a recession.

Meanwhile, the stock market is showing more optimism. The S&P 500 has experienced several sharp one-day declines in the past six weeks, but has rebounded each time. The index is up 18% this year and is just 0.7% away from its all-time high.

Analysts said the stock market reflected investor optimism that the Federal Reserve can avert a recession. Big gains in technology companies, which some see as having less impact on the overall economy, also supported the indexes.

So which view is correct? Many investors note that this is similar to what happened late last year, when bond markets quickly priced in six rate cuts from the Federal Reserve through 2024.

“I think markets tend to go to extremes,” Rieder added. “I don’t see a lot of evidence that the economy is heading for a recession, at least not in the short term.”

Economic data has been mixed lately. Nonfarm payrolls in June and July were lower than initially reported, but wage growth improved in August. The unemployment rate rose slightly but remains at a healthy 4.2%. Layoffs have been rare. Data last week showed that the number of people applying for unemployment benefits in the latest week was roughly the same as a year ago.

The latest CPI report showed inflation fell to 2.5% in August, the fifth straight month of decline and the smallest increase since early 2021. U.S. factory activity has slowed, with data pointing to weak demand.

Short-term Treasury yields, which reflect traders' expectations for where benchmark interest rates are headed, have fallen sharply since the start of the summer. The 2-year Treasury yield fell to 3.575% on Friday, its lowest level this year.

Long-term Treasury yields also fell, with the 10-year Treasury yield at 3.648%, down more than a percentage point from its April high. Bond yields fall as prices rise, and nervous investors flocking to ultra-safe U.S. Treasuries can cause yields to fall.

“The bond market seems to be pricing in more rate cuts than we expect, and we’re expecting a soft landing with 2% GDP growth,” said Alicia Levine, head of investment strategy and equities at BNY Wealth. “I think the bond market tends to overprice rate cuts and then pull back as the data shows that’s not the case.”

While few on Wall Street are predicting a recession anytime soon, most agree the risk of one is higher now than it was just a few months ago.

Lower-income consumers in particular are showing signs of stress, with credit card and auto loan delinquencies rising. While the largest publicly traded companies have been largely insulated from higher interest rates because of their large cash reserves, smaller businesses that rely more heavily on debt are feeling the pinch from higher interest payments.

David Kelly, global chief strategist at JPMorgan Asset Management, said the large rate cuts forecast by futures markets reflect this additional risk.

“I think there are two possible outcomes here: the economy has a soft landing and the Fed can slowly cut rates as they plan to do. Or, there’s a 30% chance that everything goes horribly wrong and we go into a recession and the Fed panics and cuts rates aggressively, and I think the futures market is reflecting a weighted average of those two views.”

The article is forwarded from: Jinshi Data