The Federal Reserve's Battle Against Inflation Continues with Rate Cut Considerations

The Federal Reserve has enacted the most substantial interest rate hike in over two decades, aiming to curb rampant inflation. As the economy's strength potentially fuels a rebound in inflation, speculation emerges about the continuation of rate hikes and their duration.

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The burning question on investors' minds pertains to the duration of these elevated rates, rather than debating the exact peak rate or the number of future rate increases. Austan Goolsbee, President of the Federal Reserve Bank of Chicago, highlighted this perspective shift, emphasizing the importance of understanding the sustained period at these heightened levels.

Anticipation of the next phase of the Federal Reserve's strategy prompts some investors to speculate on potential rate cuts as early as the upcoming year. This speculation is partly rooted in concerns of a potential economic downturn. Should the spike in unemployment due to increased interest rates occur, the Fed would likely counteract this by implementing rate cuts to mitigate job losses, aligning with their mandate for maximum employment.

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However, the Federal Reserve hasn't indicated any inclination towards rate cuts at this point. In fact, minutes from their recent July meeting suggest quite the opposite—a stronger possibility of more rate hikes throughout the current year.

The Federal Reserve's bold stance has sent ripples through the bond market, leading to an uptick in long-term yields. The yield on the 10-year US Treasury note reached a high of 4.3%, a level not seen in over a decade.

The discrepancy between market expectations and the Federal Reserve's guidance is evident, with the bond market displaying pessimism regarding the economy, projecting four rate cuts. Conversely, the stock market appears less pessimistic. Mike Hackett, Chief of Investment Research at Nationwide, emphasized the historical reliability of bond markets as indicators but noted their recent heightened pessimism.

Rate cuts would signal the Fed's intent to stimulate an economy facing insufficient performance for achieving full employment. Conversely, their indication of rate hikes implies a belief that the US economy remains overheated and potentially inconsistent with a targeted 2% inflation rate.

Bond investors' sentiment holds weight, historically serving as a reliable barometer. Nevertheless, the last two years have seen bond markets exhibiting remarkable pessimism.

Apart from potential rate cuts during economic downturns, the Federal Reserve could also consider rate cuts if inflation drops below the 2% target. Eugenio Alemán, Chief Economist at Raymond James, suggested that such rate cuts would only be pursued if inflation data warrants it.

Even when rate cuts eventually commence, experts believe that the Federal Reserve won't revert to ultralow interest rates akin to pre-pandemic times.

The US economy's impressive performance during the summer has kept some Federal Reserve officials on edge concerning achieving the 2% inflation goal. July saw the Consumer Price Index increase by 3.2% compared to the previous year, outpacing June's 3% rise. This marked the first instance of a general inflation increase in over a year, although core price upticks continued to decelerate.

Both the Federal Reserve and investors are closely monitoring consumer spending patterns. This behavior could either trigger more rate hikes if spending escalates excessively or prompt a recession with an increased likelihood of rate cuts if spending slows abruptly. US retail sales in July grew by 0.7% from the previous month, a marked acceleration from June's 0.3% gain.

Melissa Brown, Global Head of Applied Research at Qontigo, pointed out the dual implications of consumer spending trends on equity markets. Sustained consumer spending could reinforce the Federal Reserve's tightening trajectory, potentially unsettling equity markets. Conversely, insufficient consumer spending might signal an impending recession, aligning with yield curve predictions over the past year.

"Lehman Moment" Concerns in China

A significant Chinese investment trust, Zhongrong Trust, has defaulted on payments to corporate investors. This event has raised alarm bells, underscoring apprehensions that China's property market decline might trigger a more extensive financial crisis. With millions of yuan in missed payments, the incident has led to rare protests and intensified concerns.

Zhongrong Trust, managing around $87 billion in funds for corporate and individual clients by the end of 2022, is among numerous wealth management firms operating in China. These entities offer relatively attractive returns to investors and are integral to China's "shadow banking" sector, which supplements formal banking activities and encompasses various financing mechanisms.

Ahead in the Financial Landscape

The following events are anticipated:

• Tuesday: Earnings disclosures from Lowe’s, Macy’s, and BJ’s. Fed officials Thomas Barkin, Michelle Bowman, and Austan Goolsbee deliver remarks. The National Association of Realtors releases July figures on existing home sales.

• Wednesday: Earnings reports from Abercrombie, Bath & Body Works, Kohl’s, Peloton, and Nvidia. The Kansas City Fed's Jackson Hole Economic Policy Symposium commences. S&P Global unveils August surveys gauging US business activity. The US Commerce Department publishes July data on new single-family home sales.

• Thursday: Earnings announcements from Gap, Ulta Beauty, and Dollar Tree. The US Commerce Department releases July statistics on durable goods orders. The Labor Department discloses the number of worker filings for jobless benefits during the week ending on August 19.

• Friday: Fed Chair Jerome Powell addresses the Kansas City Fed's Jackson Hole symposium. European Central Bank President Christine Lagarde also delivers a speech at the event.

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