The U.S. Federal Reserve must reduce interest rates to approximately 3% by the end of next year to ensure a soft landing for the economy, according to analysts at AlpineMacro.
The firm said in a note that despite the Fed’s current stance, the U.S. labor market is softening and may soon fall short of full employment, increasing the likelihood of undershooting the Fed’s 2% inflation target.
While the sticky shelter component has kept inflation above the target, AlpineMacro notes that U.S. inflation, excluding shelter, has already dropped below 2%.
As shelter prices decelerate and labor market slack builds, the firm explains that overall core inflation could dip below the Fed's target, further supporting the case for rate cuts.
AlpineMacro emphasizes that if the Fed is slow to respond, it could increase the odds of a recession, ultimately driving rates even lower, potentially as low as 2%.
However, they currently see a soft landing as the base case scenario, with the 10-year Treasury yield expected to settle around 3.5% in such a scenario.
"The Fed needs to cut rates to around 3% to ensure a soft-landing," they write. "Use a back-up in Treasury yields to 4% to increase duration."
Additionally, AlpineMacro suggests that as the Fed cuts rates, the U.S. dollar is likely to weaken, making the Japanese yen and the British pound particularly attractive.
They also predict that the Bank of Canada will be the next G10 central bank to lower interest rates, advising investors to stay overweight in Canadian bonds.
AlpineMacro’s analysis highlights the delicate balance the Fed must strike to navigate the current economic landscape without tipping the economy into recession.