Wall Street's Rate Cut Gamble Faces Skepticism Amid Mixed Economic Signals

Recent market actions suggest that Wall Street is heavily betting on interest rate cuts, but it might be walking into another trap. The global markets have started to recover following last week's jobless claims data, which alleviated some concerns over the weakening labor market.

Overnight gains were significant, with the Nasdaq rising by 2.87%, the S&P 500 by 2.3%, marking the largest single-day gain since November 2022, and the Dow Jones up by 1.76%. This upward trajectory continues in Asian markets today, with increases across Japan, South Korea, Taiwan, Hong Kong, and Mainland China.

A recent report indicates that the number of initial unemployment claims in the U.S. fell more than expected last week, easing fears of a labor market collapse. Specifically, claims dropped by 17,000 to 233,000, marking the largest decline in 11 months. This data helps mitigate worries about a rapidly deteriorating labor market.

Following the release of last night's data, the market has reduced its bets on a 50-basis-point rate cut in September. Currently, the probabilities are roughly equal between a 25-basis-point and a 50-basis-point cut.

Jeffrey Roach, the Chief Economist of LPL Financial, advises caution, warning investors not to overreact to a single report. He noted that if the data deteriorates rapidly, the Fed might take more decisive action by cutting rates by 50 basis points come September.

With the impending rate cuts, Wall Street is also paying close attention to the Fed's progress on reducing its balance sheet. Since June 2022, the Fed has been shrinking its balance sheet. Initially, the Fed indicated that its Quantitative Tightening (QT) program would be completed by the end of the year.

However, recent reports have cast doubt on this plan due to economic slowdown and liquidity pressure risks. If the Fed seeks to stimulate the economy via rate cuts, QT might also be halted. Conversely, if the objective remains policy normalization, QT may continue.

Market dynamics indicate some skepticism about the future of QT. Investors are concerned that a swift conclusion might not materialize given the risks associated with market liquidity and economic health. Therefore, sudden stops in QT are seen as unlikely.

In light of potential economic downturns and recent data showing a significant slowdown in U.S. economic growth, the market remains uncertain about the Fed's path. The labor market, in particular, remains a focal point of concern. If economic conditions worsen, QT might be paused.

In sum, while Wall Street aligns closely with the idea of impending rate cuts, the broader context and unknowns about QT present a complex picture. Investors should remain cautious amid these mixed signals and prepare for a potentially turbulent market environment.