Allianz: Expects the Federal Reserve to implement a precautionary rate cut of 25 basis points this month, with quantitative tightening ending by the first quarter of next year at the latest

According to the Zhitong Finance APP, Michael Krautzberger, Chief Investment Officer of Allianz Global Investors' public market, expects the Federal Open Market Committee (FOMC) to cut interest rates by 25 basis points at its meeting on October 28-29, continuing its trajectory of "insurance-style rate cuts," which may lead to a more neutral policy rate of 3.375% by mid-2026. Discussions about ending quantitative tightening are expected to heat up, with a decision anticipated in October or December, while the reduction of the balance sheet will gradually conclude by the first quarter of next year at the latest.

Given the mixed signals from the dual mandate of inflation and employment, future actions and the ultimate endpoint for rates will remain highly data-dependent. The political pressure from the Trump administration for significant policy easing adds uncertainty to the outlook. Allianz firmly believes that the U.S. yield curve will steepen. The dollar will continue to face cyclical growth and structural headwinds, supporting Allianz's view of a short position on the dollar against a basket of currencies.

After a nine-month pause, the Federal Reserve restarted its rate-cutting cycle in September, as its policy response mechanism has shifted to focus more on employment targets. Under unprecedented political pressure, Fed Chair Jerome Powell described this move as a "risk management-style rate cut," easing policy from a moderately restrictive level to mitigate potential downside risks in the labor market while inflation remains high.

In his latest speech at the National Association for Business Economics (NABE) conference on October 14, Powell noted that the economic outlook has not changed much since the September meeting, but emphasized that downside risks to employment are increasing. Against this backdrop, coupled with limited data due to the government shutdown during the meeting, it is expected that decision-makers will follow the path of least resistance and cut rates by another 25 basis points at the upcoming meeting. Historically, "insurance-style rate cuts" are rarely one-off actions. Therefore, further easing not only could replicate the scenario of three consecutive rate cuts totaling 100 basis points from September to December last year but also aligns with past "insurance-style rate cut cycles"—of the four cycles since 1980, the Fed cut rates again within 90 days after the first action in three of them.

Given the low visibility in the economic, political, and trade environment, as well as the "curious balance" of sharply slowing supply and demand in the labor market this year, U.S. policy decisions remain highly data-dependent. Upcoming inflation or labor market data (the September employment report is still delayed due to the government shutdown) may influence the FOMC's decision, but unless there are significant surprises from either side, it is unlikely to prevent a rate cut. Conversely, increasing pressure in regional banks or the private credit sector may prompt the FOMC to consider a larger rate cut of 50 basis points. However, this move must weigh its potential negative signaling effect—that is, the market may interpret it as the Fed believing the economy or financial system is weaker than previously expected.

Powell also hinted in his NABE speech that the Fed may end its balance sheet reduction in the coming months, citing "some signs of tightening" in the money markets. Although bank reserves remain "ample," officials are closely monitoring financing conditions and liquidity indicators to determine when to stop the balance sheet reduction. Decision-makers are expected to conclude quantitative tightening by the first quarter of next year at the latest, and may announce this in October or December this year From a market perspective, implementing the already priced-in 25 basis point rate cut seems to be the path of least resistance for the Federal Reserve. Conversely, if it decides to maintain interest rates, it would be a significant surprise that could trigger market volatility and a temporary pullback in asset prices. More broadly, the impact of any easing policy will depend on the market's interpretation of its motivations. The ideal scenario would be for the Federal Reserve to continue with "insurance-style rate cuts" to guard against downside risks to economic growth and employment, while these risks ultimately do not materialize, and the market is convinced that rising inflation is merely a temporary phenomenon.

If the easing policy is perceived as politically driven, especially in the case where inflation proves to be more resilient, a less optimistic situation may arise. At that point, any rate cuts may not be welcomed by investors, particularly concerning long-term Treasury yields. This could also continue to fuel the rise in gold, contrasting with past periods of monetary easing.

In any case, the risk of a significant policy misstep remains extremely high, especially considering that the Federal Reserve is once again inclined to view tariff-driven inflation merely as another form of "temporary" supply shock, which could lead the Fed to repeat its misjudgment from 2021 to 2022