Investors question Fed's rate cut amid signs of faster economic growth

By Vivien Lou Chen

Fed officials `might be easing too much, too fast right now in a way that sparks more inflation down the road,' says Brian Mulberry of Zacks Investment Management

Something unexpected is happening on the road to the much-hoped-for soft landing in the U.S.: The growing possibility of an economic reacceleration, which handed Treasury yields their biggest weekly advances in up to two years.The 254,000 jobs created in September, accompanied by upward revisions of 72,000 for July and August, gave greater credence to the idea that the world's largest economy may be expanding more quickly and not slowing down. Also supporting the view of an economic reacceleration was Thursday's better-than-expected service sector reading from the Institute for Management Supply, which reached its highest level since February 2023 and showed the sector expanded for the 49th time in 52 months.Ordinarily, such bright reports would be seen as good news for investors and policymakers. The rub right now, though, is that the data comes just two weeks after the Federal Reserve delivered an aggressive 50-basis-point interest-rate cut - citing a slowing pace of job gains before September's data and a greater confidence that inflation can move sustainably toward its 2% target, among other things.Strong U.S. data in the past two days, along with rising oil prices on the back of the Middle East conflict, has reignited some worries about inflation even as U.S. dockworkers ended their three-day strike. On Friday, traders in the bond and rates markets recalibrated their thinking about the extent to which the Federal Reserve will be able to keep cutting interest rates from a current level of between 4.75% to 5%. One- BX:TMUBMUSD01Y through 5-year Treasury yields BX:TMUBMUSD05Y jumped by up to 21 basis points each as U.S. government debt aggressively sold off. The selloff was most pronounced in 2-year notes, which left the corresponding yield BX:TMUBMUSD02Y with its biggest weekly jump since June 2022. Meanwhile, the 10-year yield finished Friday's session with its biggest weekly rise since last October.

The odds of another 50-basis-point Fed rate cut on Nov. 7 dwindled down to zero, as traders leaned toward a 25-basis-point reduction instead and also began to price in a very slight chance of no action. While fed-funds futures traders still clung to the likelihood of a big rate cut from the Fed before year-end, they pulled back on the idea that borrowing costs could drop to between 3% and 3.25%, or even lower, by next September. "We think the Fed got a 50-basis-point cut out of the way in September so it could potentially not do anything for the rest of year and stay data dependent," said Peter Azzinaro, a partner and senior portfolio manager at Agile Investment Management in Florida. "The market got a little ahead of itself, for sure, and still sees 50 basis points in cuts for the rest of the year, which may not happen."Among the people expressing doubts about whether the Fed's decision to cut rates by 50 basis points on Sept. 18 was the right thing to do was Joseph Carson, the chief economist at Alliance Bernstein. In an online post, Carson wrote that the Fed's decision to reduce rates "prematurely," following a late start to its rate-hiking cycle, "could be considered a (big) mistake." He suggested policy makers have been relying too much on academic frameworks to set the appropriate level of rates, and not enough on the economy's actual performance. David Royal, chief financial and investment officer at Minneapolis-based financial advisement firm Thrivent, said he thinks Fed officials wouldn't have made such an outsized rate cut last month had they known September's jobs report would come in so strong. And Brian Mulberry, client portfolio manager at Chicago-based Zacks Investment Management, sees a risk that the entire narrative around easing inflation may need to change. See also: Did the Fed panic? Data since 50 basis-point rate cut raises questions, says BofA Global and Fed pause on rate cuts in November now possible, says portfolio managerNoting that Friday's data included a 4% jump in average hourly earnings over the past 12 months, Mulberry, whose firm manages roughly $15.1 billion in assets, said "you get a picture of economic activity accelerating over the past four weeks.""The biggest challenge Fed officials have had in this whole cycle is achieving lower prices without being too restrictive on interest rates. It's a delicate balance and they might be easing too much, too fast right now in a way that sparks more inflation down the road," he said via phone. Interest rates "may not be able to move lower as quickly as markets had been expecting. In particular, if this reacceleration leads to an uptick in prices, and specifically in core prices, the narrative around beating inflation would have to change," Mulberry said. Meanwhile, higher Fed policy rates for longer "will continue to put pressure on the value of future earnings, especially for already-stressed balance sheets."Before the Fed's Sept. 18 rate cut, 2- and 10-year Treasury yields had fallen by more than 100 basis points from where they were around this same time last year, as market participants focused on the prospect of a string of Fed rate cuts. Now, market participants are saying "we don't need as many cuts in total and they are removing the risk of a recession and a whole ton of cuts down the road," according to Tom Graff, chief investment officer at Baltimore-based Facet, which oversees about $3 billion in assets. Graff added that he doesn't think a Fed policy error has occurred. "With the data we have right now, I would support cutting again in November because inflation continues to decelerate," he said via phone.

-Vivien Lou Chen

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10-04-24 1607ET

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