Source: Jin10 Data

UBS economists reiterated their outlook for a soft landing of the U.S. economy on Monday, expecting the Federal Reserve to start cutting interest rates in September and believing that the market may have misjudged the magnitude of the Fed's future rate cuts.

Although economic data has shown unusual volatility since the outbreak of the pandemic, some trends now appear to have been established, according to UBS.

The U.S. labor market, which overheated two years ago, has recovered to nearly pre-pandemic levels driven by strong growth in labor supply. In addition, retail sales and inflation are also showing signs of slowing. In May, the core CPI, excluding food and energy prices, rose by only 0.16% month-on-month, the smallest increase since August 2021. Although core inflation is trending downwards year-on-year, it remains well above pre-pandemic levels.

UBS economists wrote: "Housing inflation is particularly more severe than we expected, but we still believe that the slowdown in the coming months is inevitable, as information about new leases is reflected."

"We maintain our basic forecast that the Fed will cut interest rates in September, as it will receive weaker economic growth, labor market and inflation data. Although we acknowledge that the risks tend to be longer than the basic forecast for the Fed to keep rates unchanged, we still believe that the possibility of further rate hikes is small," they said.

UBS notes that according to these trends, the U.S. economy appears to be stepping into a soft landing trajectory, and the Fed can choose to cut interest rates significantly when necessary to alleviate downside economic risks.

The bank also pointed out in a report that although there is still controversy over when the Fed will cut interest rates for the first time, the end of the easing cycle is more important for investors.

UBS stressed that although expectations for Fed action have been constantly changing, the stock market remains resilient. Even after the market's expectations for the magnitude of the Fed's interest rate cuts were significantly reduced, the S&P 500 index still performed strongly this year, highlighting the role of a solid economic fundamentals.

"The first rate cut by the Fed, whether in September or December, may not make any substantive difference," UBS said.

UBS is focused on the implied neutral policy rate in the market, which will be reflected in the yield of 10-year U.S. government bonds. They believe that the Jackson Hole Economic Policy Symposium to be held by the Fed soon may scrutinize current policy restrictions more rigorously.

Recent economic data, including consumer confidence, job openings, and inflation data, all indicate that the economy is softening, prompting UBS to believe that "this softness in the data may continue over the next few months, which is enough to demonstrate that a Fed interest rate cut is justified."

They expect the Fed to cut interest rates by a larger margin than currently expected, citing a large gap between the Fed's expected long-term rate of 2.75% and the market's expectation of around 4%.

"Overall, we believe that the market underestimates the number of interest rate cuts the Fed may make during this cycle," UBS concluded.

At its June meeting, the Fed kept its policy rate unchanged, and the median forecast in the updated dot plot showed that the Fed would only cut interest rates once by the end of the year, by 25 basis points, lower than the three in March, raising concerns that the Fed may keep rates unchanged until December.

Editor/Lambor