The Federal Reserve’s interest rate cut expectations have been on a wild ride lately, driven by conflicting economic data. Early in August, a 50-basis-point rate cut in September seemed like a done deal for many market players. Some even speculated about an emergency cut to prevent a potential recession. However, this outlook has dramatically shifted. Markets now favor a more modest 25-basis-point cut, reflecting a renewed sense of economic strength.
Federal Reserve Chair Jerome Powell, during the July meeting, also tempered expectations for a 50-basis-point cut, indicating a more cautious approach. As of August 15th, the CME Group’s Fed Watch Tool shows a 75% implied market probability of a 25-basis-point cut, a significant increase from 64% the previous day and 45% the week before. Conversely, the likelihood of a 50-basis-point cut has plummeted to 25%, down from over 50% a week ago and nearly 100% after the release of the July jobs report at the beginning of the month. Betting markets tracked by Polymarket have also witnessed a dramatic decline in the implied probability of a 50-basis-point cut, falling to 14% from a peak of 68% on August 5th.
Historically, the Fed has initiated its rate cut cycles with a 50-basis-point reduction only three times since 2000: in January 2001 (dot-com bubble burst), September 2007 (Lehman default), and March 2020 (COVID-19 pandemic). Bank of America economist Aditya Bhave expressed confidence that the Fed will only cut rates twice this year, by 25 basis points each, in September and December. He argued that, given the current robust economic activity and slightly higher-than-desired inflation, there’s no need for the Federal Reserve to implement large or accelerated rate cuts.
As of now, markets are anticipating 30 basis points of cuts by September and under 95 basis points by the end of the year. These expectations were higher following the release of the July jobs report, with markets initially pricing in 48 basis points of cuts by September and 117 basis points by year-end.
The recent economic data has provided a brighter outlook, challenging the recession risk narrative. Retail sales unexpectedly surged 1% in July, demonstrating continued robust consumer spending. This increase, the largest since January 2023, followed a revised 0.2% drop in June and far surpassed forecasts of a 0.3% gain. Motor vehicle and parts dealers led the charge with a 3.6% rise, followed by electronics and appliance stores at 1.6%. Meanwhile, the number of people filing for unemployment benefits fell by 7,000 to 227,000 for the week ending August 10th, defying expectations of a slight increase to 235,000. This marks the second consecutive weekly decline since unemployment claims reached a near-one-year high of 250,000 in late July. Veteran Wall Street investor Ed Yardeni remarked, “This morning’s data tsunami showed that the labor market remains in good shape and is fueling consumer spending.”
In essence, the latest economic data suggests that the US economy is not as weak as initially perceived a few weeks ago, lessening recession risks and the need for significantly looser monetary policy. Such a policy could undermine the fight against inflation.
The shifting market expectations on interest rates have caused dramatic movements in Treasury yields. The policy-sensitive 2-year Treasury yield plummeted to as low as 3.65% on August 5th before rebounding to 4.11% on August 15th. Similarly, the 10-year yield initially dipped to 3.66% before climbing back to 3.95%. Long-dated Treasury bonds, as tracked by the iShares 20+ Year Treasury Bond ETF TLT, had rallied 9% from July 24th to August 5th before pulling back 3% through August 15th.
