Markets Are Betting on a Flurry of Rate Cuts. They’re Often Wrong.

Federal Reserve Chair Jerome Powell. Photo: Al Drago/Bloomberg

Financial markets are betting the Federal Reserve will cut interest rates several times over the next few months. Investors are likely setting themselves up for disappointment.

It’s well understood that the Federal Reserve will lower its benchmark interest rate at its Sept. 16-17 meeting. Data have shown some areas of the economy are growing slowly. Fed Chair Jerome Powell gave a strong signal at last week’s Jackson Hole event**,** saying that the central bank could soon adjust its policy stance.

Now, the federal-funds futures market is pricing in a 90% probability of a September cut, according to CME Group data. That’s one factor that has sent the S&P 500 to many new highs this year.

The problem, however, is that markets also believe there will be more rate cuts beyond September. That could be a recipe for a stock market dip.

Futures pricing also reflects an 86% probability of a second cut by December. The market’s expectation of where the fed-funds rate will land in the long term—the so-called “terminal rate”—represents a total of just over four cuts of a quarter percentage point each.

While interest rates could drop by that much over time, they’re unlikely to arrive there within the next few months. Historical data show fed-funds futures often overestimate the move in interest rates in either direction, according to RBC data.

In early 2024, after the Fed had finished a yearslong journey of hiking rates to a target range of 5.25%to 5.5% from around 0%, fed-funds futures forecast that the central bank would slash rates all the way down to 3%, according to the terminal rate. That was far off: The actual fed-funds rate today is at a target range of 4.25% to 4.5%.

In the second half of 2024, the terminal rate dropped to roughly 2.8% after weak employment data caused markets to anticipate a series of Fed cuts. That also presumed too many cuts, and the terminal rate gradually returned to above 4% by the beginning of 2025. Now, it’s back down to about 3.2%

That fluctuating rate forecast could end up burning investors.

“Beware of the whipsaw in Fed pricing,” writes RBC’s head of rates strategy, Jason Daw, who warns that just one larger-than-expected jobs number could force markets to roll back the number of rate reductions they expect.

“Over the past two years Fed cut expectations have been deeply entrenched in the market psyche, with sizable oscillations,” Daw writes. “While the market is convinced the stars are aligning for the Fed to restart easing, the recent history of narrative shifts offers a cautionary tale.”

To that point, inflation is still a concern. While it is close to the Fed’s goal, it’s still above it, and could remain there for a while. Tariffs are a key contributor, as U.S. companies continue to pass along higher import costs to consumers. As a result, there’s a risk that coming inflation data will reflect even more price increases. That could prevent the Fed from lowering rates further after September, to keep inflation in check.

Lower interest rate increase economic growth, but the Fed only wants to chase down that reward if the risk of higher inflation doesn’t increase too much.

If the Fed decides not to cut after September—which is totally conceivable—stocks would falter. As the terminal fed-funds rate has dropped this year, the S&P 500 has notched a 10% gain year to date, in a rally that includes most sectors.

Of course, partly sparking the rally have been stellar earnings reports and profit outlooks, which call for continued sales and earnings growth. But underpinning the market’s confidence is its belief that rates will drop enough to support more economic growth. A hawkish Fed tone next month could force the market to expect a higher terminal rate, and trigger a downturn in stocks.

That means now isn’t the time to buy more stocks. The Fed might disappoint the market.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com