Rising recession risks have led two-year Treasury yields to plummet to their lowest levels of the year, prompting market expectations for more than the 75 basis points (bp) of rate cuts, Citi said in its note Friday.
According to Citi, “the dovish pricing is appropriate given the inherent asymmetry” in the Federal Reserve’s potential actions.
Citi suggests that the Fed is likely to cut 25bp at each meeting even during a gentle economic slowdown. However, analysts also indicate that the Fed “could cut 50bp at one or more meeting should data deteriorate faster.”
This outlook hinges on economic data, particularly the jobs report, where Citi projected 150,000 payrolls and an increase in the unemployment rate to 4.2%. Unemployment, in fact, rose to 4.3%, according to the data reported today, with non-farm payrolls coming in at 114,000.
The bank notes that Federal Reserve Chair Jerome Powell emphasized that with policy rates above 5%, the Fed is “well positioned” to respond to unexpected economic weaknesses.
Analysts add that recent economic indicators, such as a rise in initial jobless claims to 249,000 and a drop in ISM manufacturing to 46.8, suggest that the Federal Open Market Committee (FOMC) might need to implement at least 25bp rate cuts at each of its upcoming meetings, possibly more.
Citi notes that policy rates are currently restrictive, slowing the economy and increasing the unemployment rate. With the labor market already as loose as it was pre-pandemic, the FOMC is unlikely to allow the unemployment rate to rise much further.
Analysts explain that to prevent this, the Fed may need to move to a neutral stance, with policy rates closer to 3%. This transition could be accelerated if economic data continues to decline.
To cushion the economy and preserve the strength in the labor market, the Fed would need to ease financial conditions,” wrote the bank. “But now financial conditions are tightening even as the Fed prepares to cut rates.”
Therefore, the bank believes the Fed might need to “over deliver cuts relative to what’s priced in to support the economy,” according to Citi.
Conclusion:
As economic uncertainties loom and recession risks continue to rise, the Federal Reserve faces mounting pressure to take action. Citi’s analysis suggests that more rate cuts may be necessary to counteract the effects of a slowing economy and prevent further increases in unemployment.
With key economic indicators pointing towards potential challenges ahead, including a recent uptick in jobless claims and a decline in manufacturing activity, the Federal Reserve must carefully consider its policy decisions in the coming months.
Looking ahead, it will be crucial for the Fed to closely monitor economic data and be prepared to adjust its stance accordingly. As the labor market remains a key concern, maintaining a balance between supporting economic growth and keeping unemployment in check will be paramount.
In the face of tightening financial conditions and an increasingly fragile economic landscape, the Fed may need to go above and beyond market expectations to stabilize the economy. By being proactive and responsive, the Fed can help mitigate the impact of potential downturns and pave the way for a more resilient future.
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