Fed Rate Cut – There’s No Turning Back
Gary Dugan, Chadi Farah, Bill O'Neill
The Global CIO Office
- Jerome Powell gives an emphatic message that the Fed will cut rates
- The market expects measured rate Fed cuts, at 25bps per meeting, over the next six months
- The pace of rate cuts will be data dependent and could be more aggressive if the labour market shows further weakness
- The dollar’s recent weakness may encourage investors to seek opportunities away from the US.
- Be mindful that history tells us that US rate cuts don’t necessarily mean better times for US equities
Federal Reserve Chairman Jerome Powell delivered an emphatic message at the Jackson Hole symposium last week, noting unequivocally that “It is time for policy to adjust.” He also noted his concern about the weakness in the labour market. Powell’s comments mark a significant turning point for the policymakers—and the markets. Aside from Japan, central banks are almost all set on a path of bringing interest rates down after years of fighting inflation.
The markets are pricing a 34.5% chance of a 50-basis-point cut and a 65.5% chance of a 25-basis-point cut in the Fed funds rate at the Federal Reserve’s 17th-18th September meeting. With the Fed now firmly in the driver’s seat, the markets will be on an intense data watch. To begin with, the markets will be glued to the September jobs report due out on Friday. On the inflation front, the release of the PCE data will likely confirm – to the market’s comfort – that inflation is slowly drifting toward the Fed’s target. The market expects a headline rate of 2.6% compared with 2.5% the previous month.
Table 1: Pricing of Future Fed Rate Cuts
Source: Bloomberg
Meanwhile, retrospective revisions to US employment data released last week reinforced the view that the US labour market is far less robust than previously thought. The US Bureau of Labour Statistics reduced its previous estimate of the number of workers added to the workforce from March 2023 to March 2024 by 818,000. That implies the economy added 174,000 jobs per month on average, far fewer than the 242,000 that was initially announced. One suspects that if the Fed had been looking at the revised data in the last meeting, they might have already cut interest rates.
As events have developed in the United States, analysts are looking to other parts of the world to see how the monetary authorities react to these developments. In essence, the Fed’s decision to indicate that rates are peaking and are likely to fall going forward should embolden other central banks to cut interest rates when appropriate.
But we have an outlier in Japan where we are looking for quite the opposite on interest rate policy. Analysts are trying to gauge when the Bank of Japan may increase interest rates further. The best way of assessing the situation is that policymakers in both the United States and Japan are aiming to normalise interest rate policy but are approaching it from very different directions. This week, Japan sees a slew of data releases. Economists expect Tokyo consumer inflation to decline to 1.9% year over year in August from 2.2% in July. The government’s temporary energy subsidy programme has brought inflation down. Hence, investors should not consider weaker inflation as a challenge to the Bank of Japan’s recent hawkish stance on interest rates. The strength of the Japanese economy should be evident in July’s industrial production data, which the consensus expects to bounce back to a 3% month-over-month increase, reversing the 4.2% drop we saw in June.
Asian markets should benefit from the recent weakness in the US dollar. The dollar index lost 1.7% last week, its fifth consecutive drop and the largest weekly decline this year. A cut in interest rates should allow Asian countries to follow their own timely plans on rate cuts as their currencies will be under less pressure.
Chart 1: US Trade-Weighted Index Drops to the Low End of Trading Range
Source: Bloomberg
In Australia, the central bank has been reluctant to cut interest rates because of persistent inflation. The July inflation report will provide some good news. A combination of seasonal influences and a slowdown in food price inflation should allow for a near-flat month-over-month change in inflation. The Reserve Bank of Australia does not foresee inflation falling back to the 2%-3% target until late 2025, but the market disagrees and prices a 90% chance of a rate cut by the end of the year, and at least three rate cuts in 2025.
The New Zealand dollar (+2.8%) has been a key beneficiary of the dollar weakness, and European currencies are slightly behind. The Swedish Krona has appreciated by 2.6%. The euro is now back to its highest level since July 2023, and the UK sterling has enjoyed its best period since March 2022.
The ECB monetary council members have just started to consider whether a further cut in interest rates could be justified at the next meeting. This week’s eurozone inflation data is crucial. If inflation falls slightly or comes in line with expectations, this will hopefully cement the idea of a rate cut. However, it may also bring about some profit, taking on the EUR’s recent appreciation against the dollar.
Equities may not necessarily be a winner from the rate cuts – it just depends
Attention has turned to equity markets as a potential winner from falling interest rates – if only it were that easy! The Fed last cut policy rates from around the current level in September 2007; the equity markets fell for the next 18 months. When the Fed was cutting rates, the financial system was in a meltdown. Hence, the equity markets’ reaction to rate cuts is not just about the positive effect of easing monetary conditions but also whether those steps keep pace with a probable economic slowdown. The previous peak in US interest rates was in December 2000, when rate cuts could not compensate quickly enough for the impact of the collapse in tech stocks. The US equity market again didn’t bottom until October 2002.
Chart 2: Fed Funds Peaks do not Necessarily Lead to Equity Market Rallies
Source: Bloomberg
Our strategy is to look for investment opportunities outside of the US where the economic recoveries are earlier in their cycle and where the dollar’s weakness will allow for some countries to potentially accelerate their rate cuts. The broad EM block should benefit away from China.
