Fed set to cut rates in first easing step

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In March 2022, the Federal Reserve embarked on one of the most aggressive policy-tightening journeys in its history to combat inflation after the pandemic. Two and half years and 525 basis points later, the time has come to turn the page.

The US central bank is widely expected to kick off its easing cycle following the conclusion of the Federal Open Market Committee meeting today, as inflation and the labor market have cooled significantly. What remains uncertain is whether policymakers will start the cycle with a 50- or 25-basis-point rate cut. The latest CME FedWatch data showed a 65% probability for the former.

The much-anticipated event has broad implications beyond the US economy and markets. Here are the key aspects likely to shape market sentiment in the coming days and weeks:

The rate decision: Recent data have been consistent with an economy that is headed for a soft landing, but they do not appear to be weak enough for the Fed to cut interest rates aggressively, in our view. Industrial production rose 0.8% in August, versus expectations for a 0.2% gain. Retail sales rose by 0.1% from July, after an upwardly revised 1.1% increase in July. The consensus had been for a pullback after such a large gain in the prior month. Earlier, core inflation in August rose by a higher-than-expected 0.3%, while the unemployment rate fell slightly to 4.2%. However, as markets have priced in more than 25 basis points of rate reductions for this meeting, a smaller cut could disappoint some participants.

The “dot plot”: Alongside the rate decision, the Fed will also publish its quarterly economic projections that include a dot plot showing how far and fast top officials expect rates to fall. This could ultimately have a greater impact on the market than whether it cuts 25 basis points or 50 basis points in specific months. We see the Fed’s current policy rate of 5.25-5.50% around 200 basis points above neutral, and expect the central bank to bring rates down to that level by the end of next year.

The tone of Fed Chair Jerome Powell. Whether the Fed cuts by 25 basis points or 50 basis points, markets will be looking to Powell’s comments at the post-meeting press conference in search of clues about the Fed’s thinking in its policymaking process. A dovish Powell is likely to be risk positive, as it signals the Fed’s focus has shifted from fighting inflation to averting a recession. Historically, Fed rate cuts in non-recessionary periods have been favorable for equities.

Overall, while volatility could rise as markets reassess the Fed’s standpoint, what matters more, in our view, is that the Fed’s move further advances the global rate-cutting cycle. We recommend investors manage their liquidity accordingly as cash yields fall. Relative to cash, we think the risk-return profile is attractive for investment grade bonds, diversified fixed income portfolios, and “quality” equities with high and sustainable dividends.