Rate Hike at Fed's July Meeting Provides a Credibility Test, With Cuts Already on Horizon

As the U.S. Federal Reserve prepares to announce an expected steep interest rate hike this week, traders in traditional markets are already preparing for a rate cut coming as soon as next year.

Most economists and investors believe the central bank's Federal Open Market Committee will raise interest rates by 75 basis points, or three quarters of a percentage point, at the FOMC’s two-day meeting in Washington, D.C. That meeting will be followed on Wednesday at 2 p.m. ET by a highly anticipated statement outlining the decision.

Some traditional market analysts, however, seem to be pricing in rate cuts by the Fed coming early next year, ostensibly as part of a future move to stop the U.S. economy from a deeper recession. Those analysts might be thinking the economy is too weak to handle higher rates, or they doubt the Fed’s resolve to maintain tight financial conditions if markets continue to swoon, or some combination.

The futures market for federal funds on Chicago’s CME exchange shows that traders are pricing in an expectation of rate hikes through next January, but betting that the Fed will start cutting rates in February and continue doing so for at least the next several months.

Such a pattern would be similar to the Fed’s tightening in 2019, when central bankers first decided to take a “wait-and-see-approach” after hiking four times in 2018. The FOMC ultimately started cutting rates in October 2019 because of a slowing economy, admitting it was wrong about the outlook on the U.S. economy.

Inflation is still running at a four-decade high of 9.1%, largely a result of strong consumer demand resulting from the coronavirus pandemic. The Fed is trying to curb that demand by raising interest rates.

But this week could provide one of the most crucial tests of the Fed’s credibility if it ultimately ends up backing off from its campaign at, for instance, 6% inflation, well before inflation drops back to the target of 2%.

“If they go back into easing mode with inflation still at 6%, they’re pouring money into an economy with inflation at 6%,” said Bob Iaccino, chief strategist at Path Trading Partners and co-portfolio manager at Stock Think Tank. “They shouldn’t do that, but they might.”

Decisions made by the Federal Reserve are closely monitored by bitcoin traders and crypto analysts, because broader traditional market sell-offs resulting from the macroeconomic environment have correlated strongly with movements in crypto markets.

Bitcoin fell about 3.5% in early Monday trading hours in anticipation of the Fed’s decision on Wednesday.

While a 75 basis point hike would bring the federal funds rate to 2.25% on the lower end, many economists argue that a more aggressive hike, for example 100 basis points, would be more appropriate and bring the Fed to where it wants to be, which is 3.25%.

“If you listen to the Fed’s own narrative about where policy needs to be, it's pretty clear that they now believe monetary policy should be restrictive,” said Brian Coulton, chief economist at Fitch Ratings. “There would certainly be a very clear logic to go 100 basis points, and I wouldn't be surprised if that's what they did.”

As the de facto global bank to the world, the Fed has to respond to conditions in the foreign-exchange market, which is why the recent decision by the European Central Bank (ECB) to raise interest rates by 50 basis points could force the U.S. central bank to hike more aggressively.

The surprising rate hike by the ECB put pressure on the euro in the short term, according to a report from Coinbase (COIN). It was also in bitcoin (BTC) and ether (ETH) outperforming many of the most heavily traded currencies in the world, including the euro, the British pound and the Japanese yen.

Fed Chair Jerome Powell continues to insist the U.S. economy is far from a recession because of the strong labor market, but opinions differ widely. Former Treasury Secretary Lawrence Summers said Sunday on CNN that a soft landing is “very unlikely.” He added that “we do need strong action from our central bank,” but didn’t say if he thinks a 75 basis point or 100 basis point move would be more appropriate.

Some, like Ark’s Cathie Wood, think the U.S. is already in a recession.

The U.S. Bureau of Economic Analysis (BEA) is set to release a new report showing a decline in economic activity in the second quarter of 2022 as measured by the gross domestic product (GDP).

A popular tracker from the Atlanta Fed, the GDPNow gauge, predicts that GDP declined by 1.6% in the second quarter of this year, which would be the second consecutive quarter of declining economic activity, which is what most economists were taught is the definition of a recession. But according to the National Bureau of Economic Research (NBER), a declining GDP on Thursday won’t be a reason to worry.

“The Fed can’t say that they’re trying to push the economy into a recession, but in my opinion they are, because that’s the only thing that’s going to slow down prices,” Iaccino said.

“It wouldn't surprise me if they shocked us with 100,” he said, referring to a 100 basis point rise. “They’re trying to drive the economy into a mild recession and they know that asset prices are going to suffer, but they need that, if it’s in a slow controlled way.”