Expectation of Fed rate cut seems an over-reaction, so reality may be different

Herd instinct is the human nature to follow the crowd and act collectively - and market expectation always does not change smoothly but tends to over-react to new information. The current market expectation of the US Federal Reserve's rate cuts is a case in point.

On June 20, the latest meeting of the Fed's policy-setting Federal Open Market Committee shrugged off the market's high expectation of rate cuts and gave no clear policy signal confirming a cut.

We believe the market had overreacted in forming its expectation of rate cuts after the Fed swiftly adopted a dovish tone from the end of last year. Specifically, we believe market expectation - it has formed since May - of a change in policy stance, as well as the timing and degree of rate cuts, may not fully materialize.

We will elaborate on this now. It should be noted the misconceived expectation of Fed rate cuts could induce a drastic reversal in investor sentiment and asset price fluctuations, if the Fed's moves miss expectation.

Firstly, the market may have overestimated the degree of the Fed's policy stance change. A clear rate cut signal may not emerge until the end of this month.

According to Bloomberg, the Fed funds futures market has recently priced in a 98.5-percent chance that the Fed will lower rates at least once this year.

However, the Fed's earlier forward guidance only indicated the end of monetary policy normalization, which does not necessarily point to the beginning of a rate cut cycle. Also, the Fed has removed the word "patient" from the latest FOMC meeting statement but did not confirm a rate-cut stance.

We believe that because of the following two reasons, the Fed is still on cautious lookout, and there will not be any clear rate cut signal or plan until the next FOMC meeting at the end of this month.

Externally, the Fed is expected to stand pat until trade dispute uncertainties ease, to give itself an advantage in its game with the US Administration.

The Fed would put itself in an unfavorable position if it initiated a rate cut before major uncertainties over the China-US trade dispute are removed, because the pre-emptive move may encourage the US Administration to escalate the trade dispute, which will in turn pose a dilemma to the Fed.

That's because any escalation in trade tensions will, on the one hand, dissipate and even offset the easing boost from rate cuts and force the Fed to accelerate the rate cut pace. On the other hand, the escalation could further fuel imported inflation, which will significantly reduce the Fed's room for rate cuts. The Fed will then face a policy-making dilemma of whether to further cut rates.