Traders May Be Betting on Aggressive Fed Rate Cuts Once Again

It appears that traders might have prematurely anticipated aggressive interest-rate cuts from the Federal Reserve between now and the end of the next year. According to Jim Reid from Deutsche Bank, traders are currently pricing in 175 basis points worth of cuts over the next 18 months, the highest level of expectation since early March.

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Historically, aside from a unique instance in the mid-1980s when real rates were exceptionally high, the Federal Reserve has only implemented such significant rate cuts during periods when the U.S. economy was contracting.

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Reid points out that while a recession is not off the table by the end of next year, recent economic data has only suggested a slight cooling of the economy and labor market.

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Reid argues that instead of anticipating an economic downturn, traders might be exhibiting what he calls an "inbuilt dovish rates bias." This would mark the eighth occasion since the Fed began raising borrowing costs in March 2022 that traders have bet on substantial rate cuts only to later retract those predictions.

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Reid outlines two scenarios where the Fed might implement seven rate cuts over the next 18 months. The first scenario involves the U.S. economy entering a recession by the end of 2025.

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The second scenario considers the peculiarities of the post-pandemic economy, where the central bank could potentially lower borrowing costs aggressively without a recession and without reigniting inflation. This latter scenario would represent an ideal "soft landing," but Reid considers it unlikely.

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Investors are eagerly awaiting more guidance from Fed Chair Jerome Powell later this week regarding the central bank’s plans for rate cuts. Many traders are nearly certain that a rate cut will occur in September.

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Whether or not Powell indicates that a September rate cut is forthcoming could have significant market implications. The recent shift away from megacaps and semiconductor stocks toward small-cap stocks this month has largely been attributed to renewed hopes for rate cuts following a softer-than-expected June inflation report.

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For example, the iShares Russell 2000 exchange-traded fund (IWM) has increased by 11.7% in July, and the S&P MidCap 400 (MID) has risen by 10.6%. In contrast, the tech-heavy Nasdaq Composite (COMP) has fallen by 2.1% during the same period, according to FactSet data.

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