The Federal Reserve is preparing for its first interest rate cut since 2020, but the size of the initial rate cut and the level of interest rates three months later are still unclear.

Traders expect the Federal Reserve to announce a rate cut of 25 or 50 basis points on Thursday, with the likelihood of either option being almost equal.

Since early August, economic data has shown weakness in the labor market, triggering debates on whether the Federal Reserve is cutting rates too late, with investors showing clear 'aversion to uncertainty' sentiment. After a calm market for most of this year, the stock and bond markets have become highly volatile.

Investors are trying to determine whether recent economic data only reflects the economy returning to normal from overheating, or if it is an early sign of an economic downturn. Analysts suggest that the stock and bond markets seem to have different views on this issue.

This disagreement has led to one of the most anticipated Federal Reserve meetings in recent years. Investors will closely monitor Federal Reserve Chairman Powell's comments on the economy during the press conference, as well as the 'dot plot' of Fed officials' projections for future interest rates.

"In the past month or two, the market has been in a state of tension," BlackRock's Chief Investment Officer of Fixed Income Rick Rieder said. "The bond market has quickly shifted from optimism to recession expectations."

Interest rate derivative traders now anticipate that the benchmark interest rate will drop to around 2.75% by the end of next year, currently at about 5.25%. This would be equivalent to cutting rates ten times, by 25 basis points each time, a measure that the Federal Reserve might only take in the event of an economic downturn.

Meanwhile, the stock market has shown a more optimistic performance. The s&p 500 index has experienced multiple large single-day declines in the past six weeks, but rebounded each time. The index has risen 18% this year, only 0.7% away from its historical high.

Analysts say the stock market reflects investors' optimism that the Fed can avoid an economic downturn. The tech companies' huge gains also support the stock indexes, with some believing that tech companies have a relatively small impact on the overall economy.

So which view is correct? Many investors have noticed that this is similar to the situation at the end of last year, when the bond market quickly anticipated six rate cuts by the Fed in 2024.

"I think the markets often tend to go to extremes," Rieder added. "I haven't seen much evidence that the economy is heading towards a downturn, at least not in the short term."

Recent economic data has been mixed. Non-farm payrolls for June and July were lower than initially reported, but wage growth improved in August. The unemployment rate edged up slightly but remains at a healthy 4.2%. Layoffs are few. Last week's data showed that the latest weekly jobless claims were roughly the same as a year ago.

The latest CPI report shows that the inflation rate dropped to 2.5% in August, marking the fifth consecutive monthly decline and the smallest increase since early 2021. US factory activity has slowed, with data showing weak demand.

Short-term US bond yields, reflecting traders' expectations of benchmark interest rate trends, have sharply declined since the summer began. The 2-year US bond yield fell to 3.575% on Friday, the lowest level this year.

Long-term US bond yields have also declined, with the 10-year US bond yield at 3.648%, down more than one percentage point from its peak in April. bond yields fall as prices rise, and nervous investors are flocking to ultra-safe US Treasuries, leading to the decline in yields.

"The bond market seems to be indicating more rate cuts than we expected, and we expect the economy to achieve a soft landing, with a GDP growth rate of 2%," said Alicia Levine, BNY Wealth's investment strategy and equity director. "I believe that the bond market often overestimates the number of rate cuts, and then as the data shows that this is not the case, expectations are withdrawn."

While few on Wall Street are predicting an imminent economic recession, most agree that the risk of an economic recession is higher now than it was just a few months ago.

In particular, low-income consumers are showing signs of pressure, as credit card and auto loan delinquency rates are on the rise. While the largest publicly traded companies are largely unaffected by high interest rates due to substantial cash reserves, more debt-reliant small businesses are feeling the pressure of higher interest expenses.

David Kelly, Global Chief Strategist for J.P. Morgan Asset Management, said that the significant rate cuts predicted by the futures market reflect this additional risk. He said:

"I believe there are two possible outcomes here: the economy achieves a soft landing and the Fed can slowly cut rates as planned. Alternatively, there is also a 30% chance that everything goes awry, we fall into a recession, the Fed panics, and cuts rates drastically. I believe the futures market reflects the weighted average of these two views."

Editor/Lambor