Interest rate cut expectations are uncertain! Would it be better to ignore the Fed this time?

You can spend a lot of time studying the Federal Reserve, analyzing policymakers' statements and forecasts. Or, you can ignore what they say and focus only on their actual actions—just like the market did last week after the significant rate cut by the Federal Reserve. The most basic question is whether a 50 basis point rate cut will become the new norm. Federal Reserve policymakers say otherwise: in the next two meetings (by the end of this year), only one official predicts a rate cut of more than 25 basis points. Two officials predict no further rate cuts in their "dot plot" forecasts, while the rest predict one or two rate cuts. But who cares about what they say? The market has already embraced the dovish spirit currently exhibited by Federal Reserve Chairman Powell. Futures traders have set year-end central bank forecasts for another 75 basis point rate cut, which means that in the next two meetings, the Federal Reserve will need to cut rates by at least 50 basis points. By last Friday, they had already assigned a 25% probability to cutting rates by 50 basis points at both meetings, while the likelihood of the Federal Reserve cutting rates by the normal 25 basis points at each meeting, as stated by the majority of policymakers, is also 25%. However, ignoring the Fed's own forecasts may be reasonable, as it has been very poor at predicting its own actions. Just this year, the majority of policymakers' rate forecasts have shifted from predicting three rate cuts by the end of this year (the normal 25 basis points) to predicting one rate cut in the dot plot three months ago, and now back up to four cuts, including the two cuts last week. Why should investors believe that the Fed's forecast this time is correct? Looking further ahead, the situation gets even worse. When assessing how the Fed will respond to any economic developments, much depends on what the Fed believes the neutral rate, or the level at which rates will eventually settle in a balanced economy, will be, as economists call it. Unfortunately, there is disagreement among policymakers on the neutral rate, with estimates ranging from 2.4% to 3.8%, well above pre-pandemic levels. This significant gap reflects uncertainty about future inflation pressures, which come from the reversal of globalization, profligate governments more willing to intervene in the economy, military and green spending, and global aging populations. Currently, overnight index swap markets are pricing long-term rates higher than the forecasts of most policymakers. Furthermore, the feedback mechanism caused by the Fed's own forecasts also brings logical problems. What Powell and other policymakers expect to do often has a significant impact on bond yields and borrowing costs, which in turn affect the economy. If their communication is effective, the market will do the work for them—meaning the Fed may ultimately not need to do what it plans to do. However, this time is different. Investors have already decided that the Fed will be more dovish than it says. As a result, as traders anticipate lower rates, short-term borrowing costs are pushed down, while long-term borrowing costs are pushed up as investors prepare for stronger economic growth and inflation pressures It is rare to see such large fluctuations in such a short period of time. Last Thursday, small-cap stocks rose by more than 2% as the promise of lower interest rates eased their heavy debt costs; speculative growth companies that had been hit hard performed particularly well, and even the lowest-rated junk bonds (CCC and below) performed well, with their yields almost returning to the premium on Treasury bonds provided by the Fed after its first rate hike in 2022. This reaction is difficult to reconcile with the Fed starting a series of significant rate cuts, as the Fed has only done so in the past when an economic recession is imminent. If investors are preparing for an economic downturn, this makes sense. On the contrary, the price of long-term U.S. bonds reflects a slight increase in long-term inflation rates, with the yield on 30-year U.S. bonds rising back above 4% after steadily declining from 4.8% in April. This is actually setting the stage for perfect pricing. To meet expectations, investors need inflation rates to cool down, the job market to weaken further, so that the Fed can comfortably make significant rate cuts, without worrying about the risks of corporate defaults, stock market declines, and falling long-term bond yields that could lead to an economic recession. Certain things are likely to change, either due to economic problems or a rate cut that is less than the market expects. Perhaps investors should pay more attention to the Fed's forecasts for the remainder of the year and be concerned that long-term uncertainty implies future volatility, as the Fed navigates its way forward.