Wall Street’s outlook on Fed rate cuts is setting the stage for a “lose-lose situation,” says Deutsche Bank macroeconomic strategist Henry Allen. Markets are now discounting a 1.5 percentage point reduction over the next year in the Federal Reserve’s benchmark overnight lending rate, Allen noted in a report last week. “Historically though, we’ve only normally seen that speed of cuts within a year around a recession. Indeed, the last four times we’ve seen rate cuts that fast, it’s been because of the most recent four U.S. recessions,” he wrote. To be sure, rapid rate cuts without a preceding recession isn’t an impossible scenario, but that doesn’t mean it’s likely either, Allen noted. The historical precedent is sketchy. Paul Volcker’s chairmanship of the Fed in the 1980s, for example, saw steep rate cuts, although that followed a period of extremely restrictive monetary policy. And in the 1960s, Allen said, benchmark interest rates were also lowered while defense spending increased. In the latter case during the Vietnam War, however, inflation rose rapidly. Allen isn’t alone in his assessment of where the market’s at. Traders in the interest rate futures market are pricing in a 75% likelihood of either five or six quarter point cuts in the fed funds rate by the end of the November 2024 meeting, according to the CME FedWatch Tool . That’s more aggressive than the Fed’s own view. Minutes from the December Federal Open Market Committee meeting indicated members are penciling in just three cuts of a quarter percentage point each in 2024. Santander U.S. chief economist Stephen Stanley says investors are pricing in a perfect scenario of robust economic growth coupled with rapidly declining inflation. That tension between the Fed’s view and the market consensus means that the strength that both stock and bond markets exhibited late in 2023 will be a tough act to repeat in 2024, Stanley said. “[It’s] hard to see how both rate markets and risk markets can both continue to thrive as they have recently,” Stanley said. Stocks notched a strong 2023, which saw the benchmark S & P 500 gain 24%. Risk assets also climbed on falling inflation and a still strong economy, which also served to drive down Treasury yields. “It seems like the more realistic alternatives are either the economy remains decent but inflation is slower to fall (my view) or two, inflation slides because the economy weakens sharply,” Stanley added. Stocks have been on a less stable footing to start the new year. The latest consumer price index report for December reported last week showed inflation ticked slightly higher last month, but even that failed to dent the market’s prevailing optimism surrounding a lower interest rate outlook. “On the one hand, to get cuts” as fast as the market expects, “may well require something bad to happen, such as a recession that would not be good for risk assets,” Deutsche Bank’s Allen wrote. “But on the other hand, if the economy does hold up better than expected, then that risks creating disappointment since the rate cuts priced [in] might not happen.”
