Markets are cheering the prospect of rate cuts next year, but it's a double-edged sword

• Markets are waiting for the Fed to slash interest rates next year. 
• But that's a tricky situation for investors, as cuts would likely come in response to a slowing economy. 
• Rate cuts aren't inherently bullish and signs emerging that the economy is slowing into year-end. 

Markets are cheering the possibility the Federal Reserve could begin slashing interest rates next year, but rate cuts are a double-edged sword, Wall Street experts are warning, because of what the move would signal about the broader economy.

As inflation tumbles and the Fed continues to hold off on increasing its benchmark rate further, investors have raised their expectations for the central bank to trim interest rates in 2024. Markets are pricing in a 95% chance rates will end up lower than their current level by next December, according to the CME FedWatch tool. That optimism was  fueled this week by Tuesday's cooler-than-expected inflation report, with prices in the economy rising 3.2% in October, below the expected 3.3%. 

"I think this is a gamechanger. We're having a day of rational exuberance because the data clearly show what we've been waiting for, for a long time," former PIMCO chief economist Paul McCulley told CNBC this week. "I think it leads to the Fed now being comfortable declaring that policy is sufficiently restrictive, and that's a big deal, because it means they've finished tightening, and the next move will be an ease."

But rate cuts may not be the decidedly bullish catalyst markets are hoping for. That's because any loosening of Fed policy would likely be in response to a slowing economy, and truly deep cuts would probably come as a result of an outright recession. 

Markets have been eyeing a Fed rate cut to trigger a bullish rally in stocks. But a recession is generally strong headwind to equities. Stocks could tumble as much as 20% in event of a downturn, JPMorgan's chief market strategist estimated last month. 

"Where is the puck going? I think right now it's flying through this area of soft-landing, Goldilocks landing, but it's on its way to a slowing economy," Chris Grisanti, the chief stock strategist of Mai Capital Management said in an interview this week. "Rates don't peak for good reasons. They peak for sad reasons for equity investors ... which is that the economy is slowing, and that will manifest itself I believe over the next three to six months."

The Fed slashed interest rates before a recession in five of the last 10 downturns, according to Deutsche Bank strategists.

"This shows that rate cuts don't automatically prevent a downturn and are often a sign that problems are coming," the bank said in a note on Thursday.

According to UBS, rates could end up being slashed by 275 basis points as the economy tips into a recession sometime in the middle of next year. That's around four times the rate decline the market is expecting, meaning the economy could slow to a level where the Fed feels it has to undo a significant amount of the monetary policy tightening it enacted since March 2022. 

Cuts would be "a response to the forecasted US recession in Q2-Q3 2024 and the ongoing slowdown in both headline and core inflation," the UBS strategists warned in a note on Tuesday.

Slowing down 

Signs of a slowdown have emerged in pockets of the economy. Atlanta Fed economists are expecting real GDP growth to clock in around 2.2% this quarter. That's a dramatic slowdown from the 4.9% growth posted last quarter. 

Retail spending also declined 0.1% last month, according to US Census Bureau data. That's the first time retail spending has seen a pullback since March of this year, and it's a sign that US consumers, who have helped propped up the economy this year, may finally be starting to lose steam as their savings dwindle.

The pullback in spending is exacerbated by a cooling labor market. The economy added 150,000 jobs in October, down significantly compared to September, as the unemployment rate ticked higher to 3.9%.

Those job numbers suggest the labor market is running close to triggering the Sahm rule, a highly accurate recession indicator that flashes when the three-month average of the unemployment rate rises 50 basis points above its low over the previous 12 months.

"We're not in a recession, and yet we're getting a lot closer to the flashing red on the indicator, and it's no promise that we stay out of a recession going forward," former Fed economist and Sahm rule creator Claudia Sahm said to CNBC last week.