Fed Interest Rate Decision: Investors between Soft and Hard Landing

After four years without a rate cut, the US Federal Reserve (Fed) is on the verge of lowering the key interest rate on Wednesday. Amid mixed economic data and varied forecasts, tension is growing among bond investors. Proponents of the 'soft landing' theory argue that weak US data does not necessarily predict a recession. 'Hard landing' advocates, on the other hand, point to concerning developments in the labor market that may necessitate a severe downturn and aggressive rate cuts by the Fed. Analysts believe the Fed faces a challenging maneuver as it begins its rate-cutting course. A reduction in the key interest rate, which has been in the target range of 5.25% to 5.50% since last July, is expected. For months, forecasts fluctuated between 50 and 25 basis points (bps). According to LSEG calculations, the probability of a 50 bps cut stands at 59%, and 41% for a 25 bps cut. The futures market indicates around 122 bps for 2024 and approximately 250 bps by September of the next year. William Dudley, former President of the New York Fed, recommended a 50 bps cut on Monday in a Bloomberg article, as short-term interest rates still considerably exceed the neutral level. Byron Anderson of Laffer Tengler Investments added, "The market is definitely more pessimistic than the Fed. But someone will be wrong." Investors are also paying attention to the Fed’s quarterly economic forecasts, including the "dot plot" expectations, which provide insights into planned rate cuts by central bankers. The June projections indicated about 125 bps in cuts for 2024 and 2025, though these may be scaled back. Noah Wise of Allspring Global Investments is confident the Fed can achieve a soft landing and does not see the neutral interest rate falling below 3%. Recent CPI and PPI data met expectations and did not justify drastic rate cuts. The prospect of a soft landing leads to short-term bond strategies. Sluggish economic data and tight credit spreads also suggest such a development. However, Chris Diaz of Brown Advisory sees the risk of a hard landing, supported by a deteriorating labor market. As a result of these uncertainties, some investors have turned to 'steepener' trades, aiming at optimizing the yield curve. Current market data shows that after an extended inversion, the US yield curve is now steepening. This offers potential for further gains, according to Diaz.