The market shows signs of being excessively optimistic regarding the Federal Reserve's approach to easing monetary policy. According to recent insights from Wells Fargo Investment Institute, Fed funds futures indicate a possibility of an additional 200 basis points in rate cuts by the end of 2025. In a noteworthy decision last month, the Federal Open Market Committee (FOMC) opted to lower its benchmark lending rate by 50 basis points.
This move came as a surprise, deviating from a widely held consensus reflected in Bloomberg, which anticipated a more modest cut of 25 basis points. The recent trend saw the FOMC increasing interest rates from March 2022 through July 2023 in a bid to combat rising inflation. Investment strategy analyst Tony Miano addressed the implications of the Fed's latest decision in a detailed note to clients.
He highlighted the dual mandate of the Fed, which focuses on balancing the labor market alongside inflation concerns. According to Miano, the latest rate decision could indicate an underlying concern about the current state or trajectory of the job market, coupled with a diminishing worry regarding inflation. The summary of economic projections released by the FOMC last month reflected a median estimate among members of a total of 100 basis points in rate cuts for the current year, with projections for an additional similar reduction in 2025.
However, in contrast to this, market pricing appears to forecast a more significant total of 125 basis points’ worth of cuts in both 2024 and the following year, as noted by Wells Fargo Investment Institute. "An additional 200 basis points of rate cuts between now and the end of 2025 would likely necessitate a significantly more dire economic environment than what we anticipate or what the Fed has outlined,” Miano remarked.
He further speculated that if the economy is indeed heading toward a gradual slowdown, followed by a recovery anticipated in the latter half of 2025, the cut made in September might very well be the sole 50-basis-point reduction observed in this cycle. Looking ahead, Miano foresaw potential for inflation to strengthen sometime in the middle of next year, which he believes could inhibit the FOMC from implementing the full array of projected rate cuts.
He projected that an additional 50 basis points in cuts this year, alongside a cumulative total of 75 basis points in 2025, seems more plausible. Policymakers indicated in September their expectations for the unemployment rate to hover around 4.4% for both 2024 and 2025, while US economic growth is gauged at 2%.
Miano interpreted these projections as indicative of a labor market that is cooling off, albeit not drastically. Recent data released by the Bureau of Labor Statistics revealed that the economy added a greater number of jobs than anticipated in September, with the unemployment rate experiencing a slight decline.
Currently, markets are responding with an estimated 86% probability leaning towards a 25-basis-point interest rate cut next month, as reflected through the CME FedWatch tool, while the remaining odds favor the possibility of maintaining the existing monetary policy. Miano highlighted that differing expectations regarding the trajectory of interest rates could create avenues for volatility in financial markets, as the disparities in expectations begin to narrow.
This variance could potentially present opportunities in more speculative asset classes down the road. For the time being, Wells Fargo continues to advocate for high-quality asset investment strategies across both equities and fixed income. Specifically, Miano noted a preference for US large-cap equities alongside US intermediate-term taxable fixed income investments as the interest-rate climate evolves..