Expectations are high going into the Federal Reserve’s September meeting, with traders anticipating an up to 50 basis point cut to interest rates.
There is now an almost two-thirds (63%) probability that the Fed will cut rates by 50 basis points, according to the CME FedWatch tool.
A week ago, the probability of a 50 basis point cut was just 34% and was 25% a month ago.
Analysts at Deutsche Bank (DB), however, expect a 25 basis point cut. They believe that while there is a “compelling risk management case” for a larger move, the central bank’s communications and the balance of data do not support this.
“[Fed chair Jerome] Powell will face a communications challenge regardless of their chosen action. If the Fed opts for a 25 basis point reduction, the chair will have to project confidence about the outlook and assuage concerns about the Fed falling behind the curve,” analysts wrote in a note to clients.
“Conversely, if they cut by 50 basis points, Powell will need to avoid sending negative signals about the economy and dissuade markets from pricing a sequence of large reductions.”
If the Fed delivers a 25 basis point reduction, DB’s analysts expect the median dot to show two more 25 basis point cuts this year, followed by a string of reductions in 2025.
If it instead opts for a 50 basis point reduction, they expect 100 basis points of total cuts this year.
They anticipate rate cuts at each meeting through to March 2025.
The next big question is what happens after the Fed begins cutting rates for the first time in more than four years.
LPL Financial chief technical strategist Adam Turnquist wrote that stocks have historically traded flat to negative in the first few months after a rate-cutting cycle begins but tend to move higher over the following 12 months.
“Based on the last nine major rate hiking cycles since the 1970s, the S&P 500 has generated mixed, modest returns over the three months following the first cut, with 12-month average and median returns of 5.5% and 10.8%, respectively,” he wrote.
“Furthermore, 12-month maximum drawdowns following the first cut have been around 19% to 20%, larger declines than the average maximum drawdown for all years since 1974 of 14.4%.”
Using the same rate-cutting periods, it was demonstrated that yields tend to decline over the following 12 months, falling by an average of about 25 basis points.
Turnquist concluded: “We believe a soft landing is still viable but not guaranteed, setting stocks up for a potential volatile fall, likely exacerbated by the November election.
“Of course, how the economy holds up and if we enter or avoid a recession will ultimately dictate how stocks perform over the longer term.”