The Federal Reserve’s recent 50 basis point rate cut reflects its urgent desire to quickly establish a neutral interest rate to mitigate the risk of a recession, while its effects on the dollar could significantly impact the upcoming U.S. election, according to an analysis from ING.
Chief International Economist James Knightley, FX Strategist Francesco Pesole, and Padhraic Garvey, Regional Head of Research for the Americas, noted that the Fed‘s lack of dissent on market pricing indicates a willingness to act decisively, with only one dissenter, Governor Michelle Bowman, advocating for a 25 basis point cut. They emphasized that the Fed is “strongly committed” to maximizing employment and controlling inflation, but the immediate priority is to transition policy to a more neutral stance, given the increasing confidence that inflation is approaching the 2% target.
The analysts highlighted a general skepticism among economists regarding such a bold move in an environment characterized by a growing economy (2.5-3% growth), record-high equity markets, and low unemployment at 4.2%. They argued that the absence of clear financial stress warranted a more cautious approach, favoring a 25 basis point reduction.
A key factor driving this decision appears to be insights from the recent Federal Reserve Beige Book, which indicated that only three out of 12 districts reported economic growth in the past eight weeks, down from seven in July. With 75% of districts experiencing flat or contracting activity and corroborating data from ISM and NFIB surveys, the Fed recognized the need to shift policy from a “restrictive” to a “neutral” stance swiftly.
ING’s forecasts align with the Fed’s intention to lower rates to around 3.5% or slightly below by next summer, drawing parallels to the successful economic navigation during Alan Greenspan’s tenure in the mid-1990s. However, they caution that the current jobs market presents a more challenging outlook, with potential risks prompting the Fed to act more aggressively if needed.
The analysts also pointed out that a rate of 3% does not stimulate economic growth; thus, a more significant economic slowdown would likely compel the Fed to cut rates further.
In terms of market dynamics, ING anticipates a steepening of the yield curve following the rate cut. They observed that the market’s reaction included tighter spreads and lower net rates across the curve, while inflation expectations saw a slight uptick.
In the foreign exchange arena, ING predicts an acceleration in the build-up of short positions against the dollar. Although the dollar initially fell following the rate cut, it rebounded after Fed Chair Powell’s remarks appeared to temper expectations of further aggressive cuts. The analysis shows that net short positions against G10 currencies were already emerging by the end of August, yet these positions remain relatively modest compared to previous highs.
Looking ahead to the November presidential election, ING foresees that the evolving dollar landscape will play a crucial role. If dollar long positions unwind, a shift toward increased dollar shorts could dominate the narrative leading into the election. The analysts believe that unless job reports significantly outperform expectations, the dollar is likely to remain weak.
They predict that a potential Trump victory could trigger a sharp dollar rebound, especially if substantial short positions have developed. Conversely, if Kamala Harris wins the presidency, a gradual weakening of the dollar could continue into 2025.
