The first cut is the steepest: the Fed, market expectations and the dollar

Key takeaways

• The Fed’s rate-cutting cycle has begun, and we now see it making 25 bps cuts in each of the remaining meetings this year. If recession risks were to materialise, it has scope to ease policy more substantially
• While this was certainly a key policy meeting, the overall path of policy matters more than individual cuts. We estimate the neutral level of interest rates in the US is around 3.5%, higher than current investor projections
• With markets anticipating deeper Fed cuts compared with other central banks, the US dollar’s interest rate advantage is narrowing and we shift to a more neutral USD stance
• We see scope for the Swiss franc and Japanese yen to gain against the dollar, on limited monetary easing and limited tightening ahead respectively. We retain a cautious outlook on the euro and sterling

The Federal Reserve has made its first interest rate cut since the pandemic, reducing rates by 50 basis points (bps). We believe the Fed’s policy path is converging towards market expectations, and that means less support for the US dollar (USD) going forward. We have turned neutral on the dollar overall and the Swiss franc and Japanese yen are now our most preferred currencies.

The Fed's decision to bring rates down to 4.75-5.00% is in line with our argument that this was an ‘insurance cut’ designed to stave off further labour market weakening and frontload some policy easing. Market expectations before the meeting fluctuated between 25 bps and 50 bps. We do not see this first large rate cut as a cause for alarm, rather as a message that the Fed does not want to be behind the curve.

Fed outlook – cutting towards ‘neutral’ rates

For much of 2022 and 2023, the Fed focused on the inflation side of its dual mandate of price and job market stability. Then a series of weaker-than-expected labour reports, beginning with July payrolls, culminated in August with Chair Jerome Powell signalling a pivot from fighting inflation to focus on the Fed’s job market mandate. The Fed’s policy flexibility is in contrast to the European Central Bank (ECB) and Bank of England (BoE), which as we noted recently, lack the Fed’s flexible dual mandate of price and job market stability, and where services inflation is still elevated. In the US, 10-year breakeven inflation (a measure of long-term inflation expectations) in contrast is now back at 2%.

The September meeting delivered the 50 bps rate cut that we expected. In addition, in their updated set of projections, Fed policymakers pointed to two additional 25 bps cuts in the remainder of this year, followed by a total of 100 bps of cuts in 2025 and 50 bps in 2026. Together with the language used by Chair Powell in the post-meeting press conference, we see these as a sign of the Fed’s growing confidence on the path of disinflation and its increasing focus on preserving full employment following recent data that indicated softer conditions in the US labour market. The large cut at the start of the easing cycle, along with the strong guidance for cuts at future meetings, should contribute substantially to ensuring a soft landing and limit the risk that conditions in the labour market deteriorate going forward.

At the same time, we believe market expectations of a terminal rate at 2.8% in 12 months’ time are too low, barring a US recession. In our core scenario of a successful soft landing for the economy, we would expect the neutral interest rate – which neither stimulates nor curbs growth – to be closer to 3.5%. In the event of a second Trump presidency following November’s elections, the terminal rate in this rate cutting cycle may not even reach that level, if inflation were to pick up again on fresh tariffs, tax cuts and/or tighter immigration policy.