Economists call for emergency rate cut, Goldman Sachs increases recession odds to 25%

NEW YORK (August 5) Bond traders are now betting that the Federal Reserve will announce an emergency interest rate cut amid the ‘Black Monday’ market sell-off that saw asset prices from cryptos and precious metals to stocks and oil plunge lower. 

As noted in a report from Bloomberg, at one point in early trading on Monday, the swap market was pricing in a 60% chance of an emergency 25-basis-point rate cut within the next week as the Fed looks to head off a recession. 

The focus on elevated inflation that has dominated headlines for months has all but disappeared in the wake of a crisis in the Japanese financial market which resulted in the Japanese yen plunging 13% and the Nikkei 225 falling a staggering 12.4% in trading on Monday. In absolute terms, the Nikkei lost 4,451.28 points, the largest point drop in its history, erasing all its gains for the year and pushing it into negative territory year-to-date.

This represents the worst day for the index since the ‘Black Monday’ crash of 1987. The Korean and Taiwanese markets also saw losses of nearly 10%. 

As a result of the spreading turmoil, the U.S. bond market has seen one of the biggest rallies since the banking crisis in March 2023. The yield on the U.S. 10-year Treasury briefly fell to 3.668% in the early hours on Monday and has since climbed back to 3.8%. The yield on the policy-sensitive two-year Treasury note hit a low of 3.666% before climbing back above 3.914%. 

The yield on the US2Y hasn’t been this far below the Fed’s benchmark rate – which now sits at 5.3% – since the global financial crisis or the aftermath of the dot-com crash.

While bonds rallied, stocks have plunged, with recent analysis showing that declines in just ten S&P 500 stocks, including Nvidia, Microsoft, and Amazon, have erased over $2 trillion from investor portfolios since mid-July.

Monday’s selloff, combined with weakening economic data, has increased concerns that the Fed has held interest rates too high for too long, which is pushing the U.S. economy into recession. 

“The market concern is that the Fed is lagging and that we are morphing from a soft landing to a hard landing,” Tracy Chen, a portfolio manager at Brandywine Global Investment Management, told Bloomberg. “Treasuries are a good buy here because I do think the economy will continue to slow.”

Futures traders are now convinced that the Fed will implement five quarter-point cuts through the end of the year, with 50 basis points cuts in September and November, and a 25 bps cut in December. 

According to Jeremy Siegel, professor emeritus of finance at the University of Pennsylvania's Wharton School of Business, the Fed needs to issue an emergency 75 basis-point rate cut, followed by another 75 basis-point rate cut at their September policy meeting, as the interest rates should be about 175 basis points lower from where they are now.

"How much have we moved the Fed funds rate? Zero," he said during a CNBC interview on Monday. "That makes absolutely no sense whatsoever… If they are going to be as slow on the way down as they were on the way up, which by the way was the first policy error in 50 years, then we're not in for a good time with this economy.”

Nobel Laureate economist Paul Krugman also called for an emergency rate cut following the panicked selloff in stocks. 

“I wasn't calling for an inter-meeting cut, because that might signal panic,” he tweeted. “But since we may be seeing a panic anyway, that argument loses its force. Real case for an emergency cut soon.” 

“The Fed has been berated for being slow to raise rates in the face of rising inflation,” Krugman added in a follow-up post. “But its passivity in the face of falling inflation has gone on longer, and may do much more harm.” 

While the Fed usually only implements interest rate changes during its scheduled policy meetings, it has issued early rate moves during times of extreme volatility, as was seen during the COVID pandemic and the dot-com stock crash. Monday’s market rout has seen the calls for such an emergency cut spike. 

Market watchers were already voicing concerns about the Fed’s slow response regarding interest rates last week after the central bank held rates steady, especially because central banks in Canada and Europe have already started easing policy.

Adding to the negative outlook is the fact that Berkshire Hathaway Inc. slashed its stake in Apple Inc. by almost 50% as part of second-quarter rebalancing, which further diminished sentiment in the markets after the sale was revealed over the weekend. 

On Sunday, economists at Goldman Sachs increased the probability of a U.S. recession in the next year to 25% from 15% but reassured readers that the news isn’t all bad as the economy continues to look “fine overall,” there are no major financial imbalances, and the Fed has a lot of room to cut rates and can do so quickly if needed. 

“The premise of our forecast is that job growth will recover in August and the FOMC will judge 25bp cuts a sufficient response to any downside risks,” the economists, led by Jan Hatzius, said. “If we are wrong and the August employment report is as weak as the July report, then a 50bp cut would be likely in September.”

"We now expect faster cuts because the funds rate looks more clearly inappropriately high," they added. “The Fed looks behind, having worried too much about inflation for too long and held steady in July; and the rationale for cutting now includes the more urgent priority of supporting the economy.”

As for bonds, Kathryn Kaminski, chief research strategist and portfolio manager at quant fund AlphaSimplex Group, said there is still room for fixed income to gain given the pullback in the stock market and a push by investors to scoop up bonds before yields fall even more. 

“People wanting to lock in rates creates a lot of buying pressure and there’s also risk-off going on,” Kaminski said. “The 10-year yield could go down to closer to 3% if we do get these Fed rate cuts by the end of the year.”

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