Fed Rate Cut Hopes Fade as Strong US Economic Data Boosts Uncertainty

Fed Rate Cut Hopes Fade as Strong US Economic Data Boosts Uncertainty 

Expectations for swift interest rate cuts by the US Federal Reserve are once again facing challenges, bringing renewed uncertainty to stock markets.

Recent strong economic data from the US has pushed the 10-year Treasury yield above 4%, its highest level since early August. As a result, bets on rate cuts have been scaled back, with the swap market now predicting fewer than two 25 basis-point cuts by the end of the year, compared to nearly three forecasted just two weeks ago. This shift is forcing the stock market to adjust its outlook, a pattern that has played out earlier this year.

The "higher for longer" stance on interest rates was briefly replaced by expectations of "lower and sooner" over the summer as weakening economic data suggested the Federal Reserve might implement significant cuts. However, Ed Yardeni from Yardeni Research notes that after Friday's strong jobs report, the prevailing view may shift to "no urgency to ease further" this fall, leaving room for the "higher for longer" narrative to return in the winter.

Investors have been closely monitoring US jobs and services data, both of which have delivered positive surprises. Combined with China's economic stimulus, stock markets are hovering near record highs in both the US and Europe. Yet, there are still risks ahead, including the US election, corporate earnings, and geopolitical tensions.

JPMorgan strategists, led by Mislav Matejka, remain cautious, warning that while markets have been anticipating a period of economic growth, the opposite could occur. They stress that the key factor for equity markets will continue to be the growth outlook, with a widely accepted "soft landing" scenario possibly taking longer to materialize.

Upcoming economic data, particularly Thursday's inflation report, will be crucial for market sentiment. The options market is already anticipating a potential move of around 1.1% in the S&P 500, up from just over 0.9% the previous week, according to Bloomberg data. Bank of America strategists, including Ohsung Kwon, suggest that while the market may be able to absorb a slight inflationary surprise, a more significant spike could disrupt expectations for easing and introduce more volatility.

The challenge for stock investors lies in navigating this changing outlook. It could mean betting on the strength of recent economic data, particularly in the US, or worrying about the impact of prolonged or higher interest rates.

Positioning adds to the complexity and fragility of the situation. Charlie McElligott of Nomura recently highlighted the "massive risk" of systematic investors unwinding their positions in the rates market. Equity investors are aware that significant risk reductions in other areas of the capital market can eventually spill over and cause market turbulence. This is particularly true given the rising rates and various risks on the horizon. As a result, the volatility curve shows elevated levels for both spot volatility and skew, with the VVIX trending upward.

McElligott concludes that the growing concerns have led to a "forced-hedging rush" over the past week, as investors brace for key events and aim to protect year-end performance.

Deutsche Bank's Jim Reid shares his view that the aggressive rate cuts priced in over the summer were only plausible in the event of a recession. Without a recession, he believes the rates market was overly pessimistic, a sentiment he continues to hold today.