Why the Fed will have to cut rates more than expected this year, ING says

The employment component of the ISM index plunged to 43.4 from 49.3 in July, representing the worst reading since the pandemic in June 2020.

• Weak economic data suggests the Fed will cut interest rates by more than expected through year-end, ING says.
• The firm cites rising jobless claims last week and a declining ISM manufacturing index as warning signals.
• The 10-year US Treasury yield fell below 4% for the first time in six months on Thursday.

The US economy is flashing signals of an imminent slowdown, and it's going to force the Federal Reserve to cut interest rates more than expected this year.

That's according to a Thursday note from economist James Knightley at ING Economics, who said recent data is firing off warning signs for the economy.

That data includes initial jobless claims rising to 249,000 last week, ahead of economist forecasts of 235,000, while the US ISM manufacturing index dropped to 46.8 in July, well below economist forecasts of 48.8.

When the ISM index is below 50, it signals a contraction in manufacturing activity.

And within the ISM manufacturing index, the employment component plunged to 43.4 from 49.3, representing the worst reading since the pandemic in June 2020.

That sharp slowdown in the ISM index "suggests the risk of a rapid slowdown," Knightley said.

"Today's data has given the market even greater faith the Fed will loosen monetary policy with the pricing now in excess of 75bp of cuts this year," Knightley added.

Just a few weeks ago, the market was unsure if the Fed would implement one or two 25-basis point interest rate cuts by the end of the year.

But with the 10-year US Treasury yield dropping below 4% for the first time in six months on Thursday, Knightley says the Fed needs to get moving on rate cuts sooner rather than later.

Futures markets are pricing in a 100% chance of an interest rate cut at the Fed's next FOMC meeting in September, with an 80% chance for a 25-basis point rate cut and a 20% chance for a 50-basis point rate cut, according to the CME Fed Watch Tool.

The 2-year US Treasury yield, which is often seen as a close barometer for the Federal Funds Rate, sits at 4.19%, well below the Federal Funds Rate is at 5.33%.

Fed chairman Jerome Powell is navigating an incredible balancing act as he attempts to bring inflation back down to the central bank's long-term target of 2% without plunging the economy into a recession.

But the unemployment rate is showing worrying signs and could be on the verge of surging, according to Knightley.

"So far the move in the unemployment rate from 3.4% to 4.1% has been driven by rising worker supply rather than job losses. However, should these trends in claims continue it would mean growing upside risk to the unemployment rate," Knightley said.

According to Knightley, the unemployment rate will likely jump to 4.5% by the end of the year, which is well ahead of the Fed's estimate that the unemployment rate will end the year at 4.0%.

"As such we see greater scope for Fed policy easing than they are currently admitting," Knightley said.

If the unemployment rate does jump to Knightley's 4.5% prediction by September, it would trigger an incredibly accurate recession indicator: the Sahm Rule.

"If we have further weakening in demand for workers, we start to see layoff rates move up, we're close enough to the danger zone you're moving into a recession," Claudia Sahm, the creator of the Sahm Rule, told Fox Business Network last week.