The recession is just a "bogeyman," the Federal Reserve is not behind the curve at all?

Just a month ago, the price in the interest rate futures market indicated that the Federal Reserve was expected to cut interest rates by 25 basis points only twice for the remainder of this year. However, this expected rate cut has now doubled, standing at 115 basis points as of Tuesday.

Among a series of hastily revised estimates, the most noteworthy is that Morgan Stanley currently forecasts that the Federal Reserve will cut rates by 50 basis points in September and November, and by 25 basis points in December.

This is not the first time the market has behaved so wildly, of course, and it does reflect the current market volatility during the holiday season.

However, the situation at the longer end of the curve may better illustrate investors' expectations for the entire easing cycle by the Federal Reserve in the future.

It is now almost certain that the Federal Reserve will begin cutting rates next month. The hints from policymakers at last week's meeting were very clear. But when the rate-cutting cycle will stop remains unknown.

Observing the pricing in the futures and currency markets on Monday, it can be seen that traders' expectations for the so-called terminal rate over the next 18 months have never been below 2.85%, even during the most volatile times of the day.

This is still a long way from the current policy rate, but it is still higher than the long-term "neutral" rate believed by Federal Reserve policymakers, which is currently at 2.8%, raised by 30 basis points by Fed officials this year.

Therefore, if the anxious money markets do not believe that the Federal Reserve will be forced to cut rates below the neutral level, it indicates that they do not think the future economic slowdown will be so bad, despite the spreading concerns in recent days.

At the very least, this indicates that the market is still adopting a wait-and-see attitude towards an economic recession and believes that the weakening of "restrictive" policies itself may be enough to stabilize the situation.

Another way to look at the market's expectations for the Federal Reserve's future rate outlook is to look at the inflation-adjusted real policy rate, which is currently at 2.5%, the highest level in 17 years. Since April 2023, this indicator has steadily risen from zero with the emergence of anti-inflation trends.

If the Federal Reserve's comprehensive easing cycle eventually reaches the market's expectation of 250 basis points this week, and consumer price inflation remains at a high of 3% during this period, then the real policy rate will only return to zero at its lowest. In contrast, the average real policy rate over the past 15 years has been -1.4%, so returning to zero does not mean that the Federal Reserve is heading towards any emergency mode.

Are discussions about an economic recession just speculation? The Federal Reserve will clarify all of this in the next six weeks.

Federal Reserve officials stated this week that they are not too concerned about an economic recession at the moment, but they remain open-minded in terms of policy. They also insist on making decisions based on a meeting-by-meeting basis and emphasize that a month's worth of data or market turmoil will not overly change their views.

San Francisco Fed President Daly stated that the Federal Reserve is "prepared to take the necessary measures when the economic need arises."

Part of the reason for the recession discussion is that last week's unemployment rate reading triggered the so-called Sam rule, which suggests that a 0.5 percentage point increase in the three-month average unemployment rate compared to the lowest point of the past year typically signals an economic recession However, even the founder of this rule, former Federal Reserve economist Claudia Sam, played down market concerns, pointing out that distortions related to the epidemic and weather continue to plague employment data.

Nevertheless, as the labor market softens, the Fed appears to still be prepared to cut interest rates in September, a move that will also be accompanied by updates to policymakers' forecasts, including the long-term neutral interest rate.

Before that, the Jackson Hole Symposium held annually by the Kansas City Fed will take place from August 22nd to 24th, where the Fed's long-term thoughts are often outlined in more detail.

"The Fed's decision not to cut interest rates last week was a mistake, but I don't think it will cause irreparable damage to the economy," said Kristina Cooper, senior strategist at Invesco.

In summary, this stock market sell-off is because traders overestimated the possibility of a recession and overreacted, and the interest rate market may not even be pricing in a recession at all.