Yuri Gripas/Reuters Federal Reserve Board Chairman Jerome Powell.
- Both bond and stock markets have priced in at least one interest rate cut by the Federal Reserve before the end of the year.
- Even though the Fed didn't cut rates at its June meeting, the market edged higher on perceived dovish language from Chairman Jerome Powell.
- Some industry watchers aren't convinced that a rate cut is warranted yet, citing economic conditions and shifting sentiment on the trade war.
- Read more on Markets Insider.
Perhaps contrary to popular belief, the market is not a magic ball for predicting the Federal Reserve's actions.
The Fed's decision to hold interest rates steady in June while indicating a dovish stance for lowering rates in the future sent both stocks and bonds rallying, further pricing in rate cuts that investors expect before the end of the year.
But some industry watchers are starting to question if rate cuts are actually on the horizon, pointing to the possibility that markets have misinterpreted the Fed's message.
"While some easing is likely, we suspect that investors have misjudged the Fed's 'reaction function,' and are overestimating the extent to which it will be prepared to act in the near term," Oliver Jones of Capital Economics wrote in a note Monday.
He notes that the market is pricing in more than 100 basis points of rate cuts through 2020, which is more than the Fed has ever delivered outside of a recession in the last 30 years.
In addition, he disagrees that the inverted yield curve between the 10- year US Treasurys and 3-month bonds- long-considered a sign that recession is looming -means that the Fed will act swiftly to cut rates and stimulate the slowing US economy.
Instead, any subsequent recovery from a slowing economy is probably farther away and will be less helpful than the market currently thinks, he said. If the Fed does indeed disappoint by not lowering interest rates as much as the market expects, he predicts that Treasury yields will edge up slightly and the S&P 500 will fall sharply.
Other industry watchers disagree that the US economy has slowed enough to warrant rate cuts on their own. Instead, they cite mounting global trade tension as a main reason that the Fed would move rates lower this year.
The trade war and the possibility of further escalation between the US and China has driven market volatility as of late and has been named a top fear for investors. While US and global economic data has disappointed lately, there have been mixed signals from economies this year.
In addition, the Fed has had continued to have trouble trouble meeting its target of 2% inflation, raising concerns about global growth, something Fed Chair Jerome Powell addressed at the last meeting. Trade tension has the potential to tip the scale either positive or negative.
It seems to some that amidst these ever-shifting conditions, the Fed will wait to cut rates until there is a clearer picture of what is happening in the global economy.
"In our view, the Fed doesn't seem to have a clear picture of how the larger picture is likely to turnout in the coming months, so don't bank on a rate cut just yet," wrote Ed Yardeni of Yardeni Research in a note Monday.
He also called out the shifting language of the Fed at its June meeting, when it dropped the word "patient" from the FOMC statement. Further, earlier in the month Powell said he'd do what was "appropriate" in response to trade anxiety.
But "appropriate" doesn't mean an immediate rate cut, Yardeni said. Thinking that the same language is predicting a rate cut at the next meeting may be premature, especially if the data doesn't add up.
To be sure, 100% of economists surveyed by Bloomberg currently expected the Fed to cut rates by at least 25 basis points at the July FOMC meeting. It's an outcome that would become even more likely if trade talks between the US and China deteriorate, or the situation in the Middle East escalates, as that would likely hamper global economic growth, making stimulus that much more necessary.
Yardeni says, however, that especially if the Middle East conflict leads to soaring oil prices, rate cuts might not be enough to avoid a global recession. He also isn't convinced that a rate cut is definitely coming in July, he said.
Others think that trade could have the opposite effect. John Stoltzfus, the chief investment strategist at Oppenheimer Asset Management, said in a note Monday that a resolution of the US-China trade conflict could prompt the Fed to reverse its course and raise rates.