Market Swings as Rate Cut Expectations Meet Reality Check

The financial markets experienced a notable shift this week. Following a robust rally last Friday, enthusiasm waned on Monday as investors began to reassess the Federal Reserve's (the Fed) commitment to cutting interest rates and the potential implications for the broader business and economic landscape.

Federal Reserve Chairman Jerome Powell's remarks at the annual Jackson Hole symposium served as a catalyst, igniting expectations of a potential rate cut. He indicated that the current economic situation "may call for an adjustment to the policy stance," a phrase markets interpreted as a clear hint from the Fed to lower interest rates.

Markets responded positively, with stock prices rising and U.S. Treasury yields declining. Many predicted that the Federal Open Market Committee (FOMC) would lower interest rates at its upcoming meeting on September 17.

However, this optimism proved short-lived. As the week began, the prevailing market mood shifted to caution. While the expectation of a September rate cut was almost priced in, experts and investors began to question what would happen next. This caution was reflected in market performance, with most U.S. indices closing lower, while short-term Treasury yields, which are more sensitive to Fed policy, rose.

Expert Analysis on Potential Interest Rate Paths

Jason Granet, Chief Investment Officer at BNY Mellon, believes that if the Fed does decide to cut interest rates, it will adopt a relatively slow pace. He suggests that Powell's remarks opened only a "small window" for a rate cut in September, not a "wide door."

Looking at the CME Group's "FedWatch Tool," which is based on futures prices, traders are placing an 82% probability on the Fed cutting interest rates by 25 basis points in September, a slight increase compared to last week, but significantly higher than the 62% recorded a month ago.

However, the path of interest rates after September remains highly uncertain. The market places only a 42% probability on another cut in October, while a second cut in December is almost fully priced in. However, the cumulative probability of cutting interest rates three times during the entire year does not exceed 33%.

Granet emphasizes that the economic data released in the remaining period until the September meeting will be crucial in determining the path of interest rates. He expects the market's focus to shift to the "pace of rate cuts" after September.

Concerns About Inflation and Economic Resilience

Skepticism about "rapid easing" of monetary policy is based on major concerns about continued inflationary pressures from tariffs and the overall resilience of the economy, despite signs of a slowdown in the labor market.

Lisa Shalett, Chief Investment Officer at Morgan Stanley, believes that despite the enormous political pressure the Fed faces, and acknowledging some problems in labor market data, the "justifications for cutting interest rates are insufficient" at this time. She wonders what problem the Fed sees that warrants such urgent intervention.

Shalett adds that uncertainty surrounds the Fed's decision due to the vagueness of inflation expectations and the Fed's ability to maintain its independence in the face of increasing pressure from President Trump and White House officials.

Shalett warns clients not to be overly optimistic about the impact of "Fed easing" on rising stock prices, noting that monetary easing cycles tend to be "shallow" in the absence of a recession, and that the sensitivity of economic entities to interest rates has decreased significantly.

Fears of Repeating the 2024 Scenario

The actual impact of the Fed's interest rate policy under current conditions has long been a subject of debate in the market. In the same period last year, the Fed began a monetary easing cycle, but it resulted in unexpected results, with Treasury yields and mortgage rates rising "in the opposite direction to easing" due to market fears that the Fed was "opening the tap too early" and expectations of strong economic growth.

This historical lesson makes Ed Yardeni, a market veteran, question the justifications for cutting interest rates. Yardeni fears that Powell's assessment that "inflation from Trump's tariffs is temporary" is inaccurate.

Yardeni emphasizes that the Fed will proceed with its plans regardless of experts' opinions, but warns against repeating last year's scenario, when the Fed cut interest rates by 100 basis points, but Treasury yields rose by the same amount.

Yardeni believes that cutting interest rates will lead to higher stock prices, but warns that the Fed's goals may not be achieved, especially with regard to lowering the cost of financing public debt and stimulating the real estate market.

On the positive side, Yardeni expects the S&P 500 to rise another 2% before the end of the year, to around 6600 points, and perhaps rise another 14% in 2026, to 7500 points.

Yardeni concludes his analysis by emphasizing that the bull market will continue, but the driver will be corporate profits. He believes that his current goals may be too conservative if the Fed decides to cut interest rates on September 17.