Don't expect interest rate cuts from the Fed anytime soon as the market overrates a Goldilocks scenario

• The Fed isn't going to cut interest rates anytime soon, according to strategists at Macquarie.
• The firm said the market is putting too much stock in a Goldilocks scenario for the economy.
• "We tend to believe that rate cuts aren't imminent," Macquarie said.

The Federal Reserve isn't going to cut interest rates anytime soon as investors continue to overweight the potential for a soft landing in the economy, according to a Wednesday note from Macquarie.

"We tend to believe that rate cuts aren't imminent. The Fed has first to move to a neutral policy bias, then to an easing bias, before cutting the policy rate," Macquarie said.

Investors likely turned too dovish towards the potential for interest rate cuts in 2024, and now they're starting to sober up. The probability of an interest rate cut at the Fed's March FOMC meeting fell to 65% on Wednesday, falling from last week's probability of 74%, according to the CME Fed Watch Tool.

And investors might still be too optimistic, as they expect six 25-basis point interest rate cuts from the Fed this year. That's double the three interest rate cuts the Fed is expecting, according to its most recent summary of economic projections.

Much of investors' hope for interest rate cuts in 2024 is tied to the narrative of a soft landing for the US economy, in which the Fed successfully tames inflation without sparking a recession and steep job losses. That's not unlike the soft landing scenario that happened in 1995, but there are also a lot of differences, according to Macquarie.

In 1994, the Fed hiked interest rates by 300 basis points but managed to avoid a recession in 1995 as they slightly cut interest rates. Economic growth when on to surge from 1996 through 1999 while inflation stayed low.

"Yet we hesitate to stretch the 1995 - 1995 analogy too much; pre-existing 'macro' conditions in 2023-2024 look very different than they did in 1994 - 1995. The Fed has tightened much more in the recent cycle, leading indicators are chronically weak, and there's no 'peace dividend' to enjoy, among other big differences with the roaring 90s," Macquarie said.

Additionally, market valuations weren't as stretched today as they were in the mid 1990s, and leading indicators of economic growth in the US didn't fall continuously like they are today, they merely leveled out.

"So, however easy financial conditions may be today, they may get tighter in coming months as the Fed keeps the policy rate well above neutral for a while longer," Macquarie said. 

As to when the Fed will begin implementing interest rate cuts, Macquarie believes the second half of 2024 is most likely, especially if economic growth shows signs of slowing. That's the scenario that could lead to "rapid" interest rate cuts from the Fed, as Macquarie expects to happen.

But before the Fed can cut interest rates, the market may be in for a surprise hawkish tilt from the central bank as they try to talk down the likelihood of swift interest rate cuts in early 2024.

Richmond Fed President Thomas Barkin said on Wednesday in prepared remarks for a speech that while the economy continues to trend towards a potential soft landing, "the potential for additional rate hikes remains on the table."

The Wednesday release of the Fed minutes could shed further light on where the Fed stands in terms of timing of potential interest rate cuts.