UBS released a report on Monday predicting a soft landing for the US economy and expected the Fed to begin cutting interest rates in September. UBS emphasized that the market usually overlooks the end of the Fed’s easing cycle and believes that the ultimate target for interest rates is more important than the timing of rate cuts. The bank concluded that the market is underestimating the number of rate cuts that the Fed may make in this cycle.
In May, the US Bureau of Labor Statistics released CPI and retail data that were below market expectations, indicating a continued cooling of inflation. Several Fed officials have explicitly stated that if economic conditions continue to develop as expected, rate cuts this year would be appropriate. In light of the US economic outlook, UBS economists reiterated their expectation of a soft landing for the US economy and predicted that the Fed will begin cutting rates in September.
UBS pointed out that despite abnormal fluctuations in economic data since the outbreak of the pandemic, certain trends now appear to be confirmed. With strong growth in labor supply, the labor market, which was severely overheated two years ago, has recovered to near pre-pandemic levels. In addition, retail sales and inflation also show signs of slowing down. In May, the core CPI, excluding food and energy prices, rose only 0.16% on a monthly basis, the smallest increase since August 2021.
However, UBS also cautioned that although the core inflation rate has declined compared to the same period last year, it is still far higher than pre-pandemic levels, especially housing inflation, which remains significantly higher than expected. But UBS believes that economic slowdown in the coming months is inevitable, considering the latest data on new leases.
UBS believes that based on these trends, the US economy seems to be entering a soft landing trajectory, and the Fed can choose to cut rates significantly when necessary to mitigate downside economic risks. In addition, in another report, UBS stated that with the release of CPI data this Friday and speeches by several policymakers in the coming days, the debate in the market about when the Fed will start cutting rates may continue. However, UBS emphasized that the market usually overlooks the end of the Fed’s easing cycle and believes that the ultimate target for interest rates is more important than the timing of rate cuts.
UBS believes that the ultimate target for interest rates can be inferred from the market’s implied neutral policy rate, which is usually reflected in the 10-year US Treasury yield. The neutral policy rate is a balance point that neither stimulates nor suppresses economic activity. UBS stated that recent economic data, including consumer confidence, job vacancies, and manufacturing sentiment, indicate a slowdown in the economy and prompt UBS to believe that the Fed is embarking on a path of easing.
UBS concluded, “Overall, we believe that the market underestimates the number of rate cuts that the Fed may make in this cycle.” The reason is that the Fed’s expected long-term neutral rate is 2.75%, while the current market pricing is around 4%. This indicates that the market has lower expectations for future rate cuts by the Fed and does not fully consider that the Fed may lower rates to its expected long-term neutral rate.
The CME FedWatch tool estimates that there is an 88.6% probability that the Fed will keep rates unchanged in July and a 66.7% probability that rate cuts will begin in September.