A Symbolic Turning Point?
Gary Dugan, Chadi Farah, Bill O'Neill
The Global CIO Office
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The past week could well be remembered as a symbolic turning point for the financial markets and fiscal policy. It highlighted the challenges posed by a Federal Reserve unwilling to toe the market’s line and cut interest rates at the pace desired by investors. It also brought to the fore mounting evidence that the incoming administration may struggle to implement Trump’s ambitious fiscal policies anticipated by the market. Together, these dynamics could result in muted equity market returns and potentially higher long-term interest rates.
Chart 1: US Fed Funds Cut By 25bps – But Now What?
Source: Bloomberg
A Deliberate Stance
While the central bank did deliver the 25-bp rate cut that was widely expected, what surprised the market was the consensus amongst the Fed Governors that US rates would be 50bps higher next year than previously thought. Clearly, by pushing back against market expectations of further significant rate cuts in 2025, the Federal Reserve has made its position clear.
As we have emphasized in recent weeks, the current inflation data does not justify aggressive monetary easing. Moreover, potential risks associated with the new administration’s economic policies argue against assuming that inflation will conveniently slip back into the Fed’s target range. In essence, there is no compelling reason for the Fed to stimulate the economy further, except to appease investor demands.
Equity markets have already risen close to 30% year-to-date, and bond yields appear to be at fair value. It’s therefore imperative to ask: Where, then, is the economic stress – or justification – that would necessitate deeper rate cuts? The only apparent strains lie in sectors such as commercial real estate, which are grappling with the consequences of earlier excesses. Against this backdrop, the Fed’s 25-bp rate cut and forecasts of future modest rate cuts not only highlight its measured approach. The Fed’s stance underscores the central bank’s independence and its reluctance to bow to market pressures.
Political Challenges: A Fractured Road Ahead
Last week underscored the stark realities facing Trump as he prepares to address the fiscal deficit and rising government debt. It should now be abundantly clear to him and his administration that there are no quick fixes for these deep-seated issues.
The new administration’s wake-up call came in the form of a fractured Congress, where even the Republican Party, ostensibly united under Trump, revealed deep internal divisions. Republican senators appeared a divided lot, defying the leadership’s efforts to secure votes for a short-term fix to what could have been a government shutdown. While the shutdown has been averted, the discord highlights two competing schools of thought within the party: one faction that advocates for strict caps on government debt and significant cuts to government spending, and the other that favours tax cuts and relies on increased tariffs and stronger economic growth to balance the books. These divisions will likely complicate efforts to implement cohesive fiscal policies. Moreover, the noise of private sector types who constantly make out that change is easy if only they could take control is starting to ring hollow. The comments from people such as Elon Musk that “America is currently headed for bankruptcy superfast” may end up only causing more harm than good.
A Broader Context of Economic Uncertainty
This confluence of central bank caution and political bickering takes place against a broader backdrop of unresolved global economic challenges. Developed economies continue to grapple with the consequences of years of excessive government spending. While the world remains in search of a solution to this persistent issue, no clear path forward appears in sight.
Implications for Financial Markets
For financial markets, the implications are clear. Investors must temper their expectations on stellar returns seen in recent years. In fact, the equity market rally may lose momentum as fiscal and monetary policies become less aligned with investor aspirations. Meanwhile, higher long-term interest rates could emerge as a byproduct of fiscal uncertainty and cautious central bank policies.
Chart 2: US Markets Stutter
Source: Bloomberg
As we look back at this pivotal week in a year’s time, it may stand out as a harbinger of what was to come. A Federal Reserve at odds with market expectations, a president discovering the limits of his influence, and a global economy still seeking answers to fundamental challenges. Investors and policymakers alike would do well to heed the lessons of these unfolding dynamics.
