The market believes in interest rate cuts, but not in a recession.

From the memorable Jerome Powell's speech in Jackson Hole A few weeks have passed, but in that time we've seen endless euphoria in the stock market. While the percentage gains aren't particularly spectacular, it's worth noting that Wall Street is practically hitting all-time highs overnight. At the same time, we've seen a relatively stable dollar, but also a number of warning signs from the American economy, primarily in the labor market.

Will the upcoming interest rate cuts actually lead to an improvement in the situation in the US, or are they a sign that the economy has taken such a hit that it will not be able to recover in just a few months?

Investors confident of a reduction

Wednesday, 20:00 PM is a key date and time this week. That's when the US interest rate decision will be announced. Investors are almost 100% certain a cut will occur. Powell announced it in Jackson Hole, citing the weakness of the labor market, and since then, the situation has deteriorated even further. Of course, inflation remains elevated, but the main risk factor under consideration, tariffs, do not appear to have as significant an impact on price dynamics as expected just a few months ago. Therefore, there will be a reduction, but it is not known how large it will be.Less than 6% probability derived from interest rate futures quotes suggests a 50 basis point cut.

On the other hand, we've already been without a rate cut for nine months, so the possibility of adapting to current conditions with a sharper cut cannot be ruled out, just as it was a year ago, when the Fed opted for a 9-basis-point cut. At the time, it was suggested that this decision might be politically motivated, although it's important to remember that the decision is made by the entire Committee, not a single individual. Furthermore, it was suggested at the time that the labor market was beginning to deteriorate, as confirmed by the latest employment revision covering the 50-month period from April 12 to March 2024. However, it is important to remember that inflationary risks still remain and, more importantly, stem from factors other than tariffs.This is still elevated service-related inflation, which is influenced by, for example, still strongly rising wages. This is something the Fed hypothetically has influence over, given its decision regarding interest ratesAt least for now, the economy appears to be in a solid position, with only the labor market showing signs of significant weakness. However, this isn't cause for concern yet, given that the Fed still sees a higher unemployment rate than it currently does.

There is no risk of recession

Therefore, it appears that a 25-basis-point Fed rate cut is the baseline scenario. Nevertheless, the market will be closely monitoring projections: those regarding the unemployment rate, inflation, and the expected path of interest rates. Theoretically, it may seem that the number of cuts in the entire cycle may decrease, although the Fed itself may give a chance for at least one more move this year.

At this point, no one sees a risk of recession. The data remains quite solid, with Wall Street indices at historic highs, although the US dollar is not performing well. The market is currently focused on rate cuts, so suggesting fewer of them could lead to dollar strengthening and a slight correction on Wall Street. On the other hand, if the Fed decides to issue a "jumbo cut," a massive 50-basis-point cut, the dollar could reach its lowest level against the euro since 2021, and Wall Street indices could surge to new record highs.

Just before 10:00 a.m. the dollar was worth PLN 3,6226, the euro was PLN 4,2501, the franc was PLN 4,5473, and the pound was PLN 4,9182.

Source: Michał Stajniak, CFA, XTB