Traders are betting the U.S. will perform an emergency interest rate cut to support the economy amid a global stock market sell-off sparked by recession fears.
The Japanese stock market dropped more than 12 percent on Monday, the biggest fall in history, as traders dumped Asian and European shares amid fears of a U.S. downturn.
Markets are upping bets the U.S. Federal Reserve will cut interest rates before its next scheduled meeting in mid-September, in what would be the first out-of-cycle decision since the outbreak of Covid-19 in March 2020.
“Markets panicked after the U.S. employment report on Friday,” said Andrzej Szczepaniak, an economist at Nomura, adding that traders are currently pricing in a 60 percent chance of emergency easing by the U.S. Fed.
Markets began plunging on Friday after a report from the U.S. Bureau of Labor Statistics corroborated fears of an economic slowdown in the U.S. The S&P 500, a stock market index, which includes some of the biggest companies worldwide, closed 1.84 percent lower, while the tech-heavy Nasdaq 100 lost 2.38 percent, reaching its lowest level since May.
The sell-off spread to Asia and Europe on Monday. The Nikkei 225 closed Monday’s trading session 12.4 percent lower than at the end of last week, while the pan-European Stoxx600 index lost around 2 percent.
In addition to a potential emergency Fed cut, markets now see the European Central Bank (ECB) going for a 0.5 percentage point rate cut at its next meeting in September.
The U.S. Fed is one of the only major central banks to keep its high rates unchanged, since major economies started a policy of monetary tightening in the wake of high inflation following the pandemic.
If there is no emergency cut before the Sept. 7-18 meeting, there will almost certainly be a decision to start lowering rates then — but Kyle Chapman, FX markets analyst at Ballinger Group, said there is no need to take emergency action.
“Big bets on an inter-meeting rate cut are a clear signal that traders are overly spooked. It is certainly time for the Fed to cut next month, but the U.S. economy is not falling apart just yet,” he said.
While other central banks have begun to ease rates, they’ve warned there will be no speedy easing, nor a return to the near-zero rates of the post-financial crisis era.
The ECB cut rates in June, from 4 percent to 3.75 percent, but held in July, warning that there is still no firm path for easing policy further.
The Bank of England took its first interest rate cut decision last week, saying the U.K. economy has cooled enough to justify a modest relaxation of monetary policy, but warned it will be careful “not to cut interest rates too quickly or by too much.”
Overblown fears?
Friday’s employment report showed that the stellar performance of the U.S. economy in the last two years might be nearing its end, as the jobless rate rose to its highest in nearly three years while companies briskly reduced their pace of hiring.
The Fed decided to keep interest rates unchanged at 5.5 percent at its last meeting on July 31, despite its Chair Jerome Powell acknowledging early signs of an economic slowdown.
And markets fear that a first interest rate cut in mid-September by the Fed could be too late to save the economy from falling into a recession.
“Global risk assets continue to correct sharply as investors fear that the Federal Reserve has left it too late to ease policy,” ING FX strategist Chris Turner said.
However, Szczepaniak said that current bets on the Fed’s rate cut seem overblown when looking at the overall picture.
“If you look at the U.S. economy, it is still growing strongly,” he explained. “Second quarter GDP growth surprised to the upside, and household consumption remains healthy without signs of materially slowing down.”
The U.S. economy was still growing at 2.8 percent in the April to June period, much faster than other advanced economies.
Emergency rate cuts are seldom employed. In recent decades, the Fed used them in 2001 after the 9/11 attacks, and amid the tech stock bubble burst in the same year, and then again in March 2020 during the Covid-19 pandemic.