The US Federal Reserve came under severe criticism in 2022, for underestimating inflation and allowing it to run off. While there were externalities linked to price hikes (the war in Ukraine), the US Central Bank was widely panned for its certainty that inflation was “transitory”. It thus set a very hawkish course for interest rates that bond markets especially were not ready for, causing the sharpest drop in bond prices in decades.
Investors thought that the Fed, which changed direction abruptly would continue to remain cautious. During the September 2024 meeting, those expectations were, by and large, disproved, with the world’s most important central bank deciding an aggressive double (0.5%) rate cut.
Economists and strategists, as well as our own House View, suggested that economic growth was good, albeit slowing, the labour market was weakening but not to the point of worry and that services inflation persisted, even as headline inflation receded, mostly due to China deflating goods. Thus, the Fed could begin easing, but cautiously, to avoid giving the impression of economic urgency. Most views were in the camp of two to three cuts until the end of 2024.
Bond markets on the other hand, positioned for a more aggressive stance, discounting four to five cuts until the end of the year.
Ultimately the Fed sided with the latter, weighing the weakness in the bond above the danger of re-insurgent inflation. Members of the committee who were seeing one rate cut in July, now see four by the end of the year. The bond market is discounting almost five.
As investors, there are several conclusions we must draw:
For one, expectations on future cuts will probably build up from this point forward, pushing bond yields further down and causing more steepening in the yield curve. If the Fed started aggressively there’s no reason why it should not continue in the same direction, the thinking will likely go. The Fed’s comments that this was an adjustment and we shouldn’t expect more big cuts in the future will do little to curb market expectations, as investors have seen the Fed move the needle towards their expectations more than once.
Second, investors will have to consider whether the US economy and corporate earnings are more stressed than what they appear to be. A central bank cutting aggressively could, even inadvertently, emit a distress signal to markets and investors. One could point to Chairman Powell’s comments about a “strong economy” during the press conference. But as the Fed has changed course time and again, those comments reflect their thinking now, rather than consistent forward guidance. In short, and this is important, the US central bank has chosen a strategy of “surprising markets”, in order to retain some flexibility. The downside is that statements about the future are now less reliable, and market speculation will increase. The Fed will thus be able to rely less on “directing” markets with statements, and instead will be more often forced to act. In a sense, “Fedwatching”, monitoring every word out of the mouth of every Fed official, a practice since 2008, is now dead.
Third, the move will likely become an issue in the very polarised presidential campaign, further fuelling a discussion as to future of the central bank’s independence.
Fourth, it will send a signal to the Bank of England and the European Central Bank that they should feel free to also cut aggressively, as they try to deal with weak growth conditions.
The Fed took a bold step, considering that services inflation is still much higher than average and that the US economy depends on China to continue deflating goods. The US central bank is now committed, in the eyes of markets, to reduce rates quickly. A paced approach would have allowed it to manoeuvre in case prices didn’t stabilise at the desirable pace. A double cut necessitates further aggressive moves or risks upsetting markets, and leaves little room to manoeuvre in case prices rebound.
Meanwhile, the Bank of England maintained rates despite a clear “green light” for more aggressive cuts the Fed’s move. Unlike its US counterpart, the British central bank is not quick to declare victory against inflation, despite facing significantly more restrictive economic growth conditions. Having said that, we would expect the Bank to pick up the pace in the next few meetings, as both the US and the ECB are on steeper rate cut cycles.