The Fed's Close Call
Gary Dugan, Chadi Farah, Bill O'Neill
The Global CIO Office
- We are hopeful that the Fed will deliver a 50bps rate cut, if not the market will likely be disappointed
- A new Fed ‘dot plot’ should forecast a steady drop in policy rates over the coming 15 months
- The Bank of Japan to signal further rate rises, but no move likely at this meeting
- The UK MPC doesn’t have a consensus for a rate cut but should find scope by the end of the year
- In China, it doesn’t get any better with the authorities way behind in offering suitable support
This is a crucial week as far as interest rates are concerned. Policymakers at three global central banks – the Federal Reserve, the Bank of England, and the Bank of Japan – meet this week to decide whether or not to cut interest rates. Central banks therefore will be very much in the headlines this week.
The Fed Meets – We favour a 50bps cut
As of the weekend just gone by, the market is pricing in a 57% probability of a 25-bp rate cut and a 43% probability of a larger 50-bp cut. While not all economic data supports a larger cut, the Fed may opt for a bold move considering the historically high real interest rates currently. Adjusted for inflation, the current Fed funds rate is 2.5%—the highest since 2007. In contrast, inflation in 2007 rose rather than fell (Chart 1). Interestingly in 2007 the rate cutting cycle started on 18 September!
If the Fed’s goal is to bring real rates down to +50bps, this would imply a target Fed funds rate of approximately 2.75%, based on a 2.25% inflation target. Achieving this would require a total rate cut of 250bps. At a pace of 25bp cut per meeting, the Fed could take roughly a year to reach its desired target.
The meeting will also see the release of the Fed’s new dot plot, which charts the top Fed policymakers’ interest rate projection over the medium term. We expect the Fed governors to indicate that rates will be lower by at least 100bps by the end of the current year at 4.25% and close next year at around 2.75%. It’s worth noting here that the Fed governors have been notoriously poor at forecasting rate changes over the past two years. Nevertheless, the market expects the Fed’s estimate for inflation over the forecast period to remain unchanged. However, unemployment rate forecasts are likely to rise in the wake of the weaker data and the comments of concerns from Fed Chairman Jerome Powell at the Jackson Hole meeting.
Chart 1: US Nominal and Real Fed Funds Rates Beg to be Cut
Source: Bloomberg
Bank of Japan meeting – Managing market expectations
The market is not expecting the Bank of Japan (BoJ) to announce any change in interest rate at this week’s meeting. However the market is expecting BoJ guidance on when the next rate cut may occur. The central bank, though, will be keen to not send a signal that re-creates the marked volatility in the currency and asset markets seen in August.
With the risk of a US recession in the markets’ eyes now diminished, the BoJ’s focus will instead be on the pace at which the Japanese economy shows sustained inflation. We believe that a further rate rise towards normalization is possible by December. Last week’s revision to Q2 GDP data showed the Japanese economy is still running at around a 3% pace and recent wage settlements have shown consistency of outcomes of wage growth of around 3-5%. The one factor that could slow the pace of a BoJ tightening is the weakness in the Chinese economy; recent economic data shows some weakness in large manufacturing company business confidence.
Chart 2: Yen strength well established
Source: Bloomberg
Bank of England – Standing pat, but biased to ease in the coming months
After the Bank of England’s monetary policy committee voting 5-4 at its last meeting to cut rates, it is difficult to see the central bank cutting rates again at this week’s meeting. However, we expect further rate cut(s) before the end of the year, given that growth remains relatively benign, and inflation is under better control. At Jackson Hole, the Bank of England Governor Andrew Bailey expressed his ongoing concern that the job was not quite yet done to bring inflation under reasonable control in the UK. However, should there be better inflation data? Given the backdrop of a relatively flat GDP growth, there would then be a good case for a further 25-bp cut in interest rates at a subsequent meeting.
Taylor Swift holding up UK rate cuts? For Taylor Swift fans we note that her concerts in the UK have had the effects of biasing inflation higher than would ordinarily be the case because of higher hotel tariffs charged around the timing of her concerts. Hence, this week’s inflation news could be biased to a higher level and give the MPC another reason to not cut!
China’s Equity Market: Increasingly Uninvestable
China’s equity market is becoming ever more challenging for investors, as the gap between economic reality and the potential for a meaningful government support continues to widen. Over the weekend, economic data releases painted a picture of sluggish growth. Industrial output for August rose by 4.5%, falling short of market expectations of 4.8%, and marking the weakest performance since March. Retail sales were similarly disappointing, growing just 2.1% in August, below analysts’ expectations of 2.5%. This is particularly notable, as August typically sees a surge in consumer spending as summer travel peaks.
Chart 3: China’s Sluggish retail sales Growth
Source: Bloomberg
Adding to the concerning outlook, Friday’s bank lending figures showed a significant shortfall. New loans totaled 900 billion yuan in August, missing market estimates of 1 trillion yuan and down sharply from last August’s 1.3 trillion yuan.
Ahead of these data releases, Chinese Premier Xi Jinping called on all levels of government to support the country’s growth ambitions. Monetary policy adjustments, such as cutting the reserve requirement ratio, are likely to be among the first steps authorities may take to stimulate the economy.
Market sentiment towards Chinese equities remains uncertain, however. As of late August, foreign investors had withdrawn $12 billion from Chinese equities since June, and the government has since restricted the publication of regular capital flow data.
Moreover, the trend of investors seeking emerging market benchmarks that exclude China is gaining traction. According to a February report by the Financial Times, US retail investors are increasingly favouring ETFs that exclude China. Over the past year, assets in China-excluded EM ETFs have tripled to $5.3 billion, while China-focused ETFs saw outflows of $800 million.
President Jinping’s leadership style, often described as steadfast, has drawn criticism for its delayed decision-making—most notably in lifting COVID-19 lockdowns. While long-term economic strategies focusing on high-tech industries, electric vehicles, and renewable energy are promising, they have yet to address China’s short-term growth challenges, particularly in the real estate and local government sectors.
Chart 4: China’s Equity Market Underperformance Shows No Bound
Relative performance to Global Equity Index rebased to Sept 2019=100
Source: Bloomberg
We remain sceptical about the potential for Chinese equities to perform, especially considering that even domestic investors have been pulling their money from the market in recent quarters. It appears that a significant intervention from the government will be necessary to reverse this trend. A combination of aggressive growth support policies and targeted funds injected into the equity market may be the only near-term solution to address the malaise.
However, even with such measures, we doubt that foreign investors will return swiftly to a market that could be perceived as ‘artificially’ propped up. The uncertainty is compounded by broader concerns, including the outcome of the upcoming US presidential election and the possibility of a substantial increase in tariffs under a renewed Trump presidency.
For Asian markets, the problems in China represent something of a headwind to performance. However, the prospect of 100bps off US policy rates by year-end will provide a good support. Asian central banks are set to follow the Fed with rate cuts, particularly given the bias of the dollar to weakness.
