FED finally cuts rates

BOE and BOJ unchanged

Market Review: In the week that the Fed cut rates for the first time in 4 years, it was probably no surprise to see the majority of equity markets higher. We even got new all-time highs from the Dow Jones and the S&P 500 index, before the rally lost steam on Friday. The surprise, if anything, was that bond markets greeted the news unenthusiastically. Yields actually rose, suggesting that much of the good news had already been firmly baked in the cake. The Emerging and Asian markets liked the news and China led the gains last week, despite their own central bank resisting the urge to cut. There was a modest outperformance of small and mid-cap, but nothing too pronounced. The currency markets were largely unchanged. Oil recovered a bit and Gold again carried on to new highs, with Asian central bank buying the most likely cause.

First Cut is the Deepest: On Wednesday, we got the first cut to the benchmark federal funds rate in four years and it was significant, amounting to a jumbo 50 basis points. In recent days, market pricing had shifted to suggest slightly better than even odds of this outcome, but most economists, outside of the trading environment, were caught off guard. Of the 113 economists surveyed by Bloomberg, only nine anticipated a cut of this size. J Powell was at pains to suggest that the greater magnitude of the move was not driven by any sudden panic about the state of the economy. This was merely a catch up on a 0.25% move they would have made in July, if they had known that months employment data ahead of the meeting.

The Federal Open Market Committee accompanied the move with a significant change in its forecasts for interest rates by the end of this year and next, shown in their quarterly Summary of Economic Projections, often called the dot plot. The median forecast for the end of both 2024 and 2025 dropped by 75 basis points. Tackling rising unemployment is now clearly the priority for the FED, but Powell was keen to convey a strategy of gradual easing that suggested cuts of 0.25% are more likely to be the norm going forward and certainly for the rest of the year.

After initially surging on the news, there was a sense of disappointment that we were unlikely to get more jumbo rate cuts. But having slept on the news, investors concluded that actually, all in all, it was still good news and markets bounced emphatically on Thursday with the S&P 500 rising above 5,700 for the first time. That said, markets are still pricing in more rate cuts than the dot plots, so there is still scope for disappointment going forward particularly in the bond markets. In fact, despite that big downward move in interest rates, the 10 year treasury yield finished the week higher whilst the 2 year dropped, resulting in a more traditional ‘un-inverted’ yield curve!

The Federal Reserve’s official dual mandate, as written down by Congress, is to Promote Maximum Employment and Maintain Stable Prices and for the moment the Fed have declared the inflation genie back in the bottle, so its all about employment. If the first bit of the mandate had instead focussed on something like ‘Maintaining Economic Growth’, there would have been a very strong case for leaving rates as they were.

As if to underline the fundamental strength of the US economy, last week, we had confirmation of; a pickup in industrial production for August; a surprising uptick in retail sales; a decrease in business inventories; a bounce back in housing starts; and most pertinent of all, an increase in the current run rate of economic growth, as the Atlanta Fed GDP Now Index went up to 3%. The conclusion – although unemployment may be rising, this appears to be a slowdown, as there is no sign of a recession just yet. If I had been buying US 10 year treasuries in to the announcement, I would be having second thoughts about holding them next year. A pickup in inflation on the back of a reaccelerating US economy should not be completely discounted at this point.

But I think equity investors had every right to cheer the move that we had waited a long time for and it was nice to see all sectors of the market moving higher. It is probably too early to make a call on which sector of the market is going to perform strongest in this next rate cut cycle, but you can probably make a strong case for smaller and mid cap which are the most sensitive to borrowing costs. I know I am guilty of being overly bullish on occasion. But, notwithstanding high valuations and the short-term headwinds of a presidential election that is too close to call, when presented with a macro backdrop of falling inflation, looser monetary policy, rising corporate earnings and stable economic growth, I cant help but think we could enjoy a decent, sustainable bull market for the next few years.

BOE Holds Rates Steady at 5.25%

The Bank of England’s Monetary Policy Committee had used the August meeting minutes to signal that rate cuts were unlikely unless the economy turned out much weaker than expected. Since then, there hadn’t been many major economic changes, leaving August’s inflation data as the key factor for any shift in policy.

In the end, the inflation data was largely as expected. CPI inflation stayed steady at 2.2% in August, with lower fuel prices offsetting rising services costs, which were affected by a temporary jump in airfares.

In the near term, inflation might even head a little higher as service inflation is still proving stickier than the Bank would like and a 10% rise in energy prices is expected to drive it higher again by the end of the year, although that if factored into the BoE’s current expectations. I still expect them to cut in November but its probably likely to be another 0.25%. This would be consistent with the MPC’s message that it will move gradually. But we might see the pace picked up around the turn of the year, perhaps to counter a more aggressive tightening of fiscal policy in the upcoming Budget.

And the chances of that happening became ever more likely on Friday as data showed that UK government borrowing came in higher than forecast in the first five months of the fiscal year, keeping Chancellor Rachel Reeves under pressure to raise taxes to balance the books in her budget next month.

The UK’s budget deficit reached £64.1 billion between April and August, £6.2 billion higher than expected by the Office for Budget Responsibility. In August alone, the shortfall was £13.7 billion, marking the third-highest August deficit on record. The national debt has now reached 100% of GDP for the first time since 1961. Higher spending on benefits, public-sector pay, and inflation-driven costs contributed to the overshoot, although tax receipts were £3.8 billion above forecasts, but overall spending exceeded projections by £11.5 billion.

Labour’s warnings about the state of public finances and the tough choices ahead are impacting sentiment, with a key survey on Friday revealing that consumer confidence fell in September at its fastest rate in two-and-a-half years. That’s annoying, I know every incoming government paints a picture of how terrible a position it has inherited from the previous incompetents, but it could become a self-fulfilling prophecy. Actually, things aren’t as bad as the chancellor suggests. Despite the higher-than-expected deficit, there is probably more budget flexibility thanks to an improved economic outlook and a continued increase in tax receipts. Retail sales released on Friday showed that for the moment, Brits are still prepared to spend, as the volume of goods sold increased 1.0% after shoppers splashed out on food and clothing during a sunny August, beating guidance of a 0.4% increase.

BOJ Holds Steady

The Bank of Japan kept its policy rate at 0.25% during Friday’s meeting. A hike is coming given recent hawkish statements from BoJ officials as they are keen to get on top of inflation, but the recent upward surge in the yen has probably put that on hold for a bit. Best guess is it’s now more likely to happen in December rather than October, and I think they were reluctant to move higher in the week the Fed cut so aggressively, as that might have resulted in unwanted currency volatility. Although CPI inflation is decreasing, it’s mainly due to easing supply-side pressures. Thankfully the recent uptick in consumer spending is still improving as inflation slows and wages rise after strong Spring negotiations, deflation now seems firmly in the rear-view mirror.

The big driver for the Japanese equity market is obviously not going to come from the looser monetary policy the Western world will benefit from, so it probably comes down to earnings and here the backdrop is encouraging. The recent drop in oil prices and the yen’s rebound could improve trade conditions for companies if these trends continue and while a stronger yen may reduce profits from overseas operations in yen terms, the firms most affected by this are large corporations, many of which have reported record profits. Moreover, the current yen exchange rate aligns with what companies had anticipated so they can live with the recent strength. These strong earnings are expected to bolster the 2025 Spring Negotiations. Although the exceptionally high wage increases seen in 2024 may not continue, solid corporate earnings and a labour shortage are likely to strengthen next year’s wage negotiations and the virtuous cycle of increased consumer spending should continue. Chart below courtesy of Oxford Economics.

China – No cuts but further housing support could be coming

The PBOC continues to confound investors as it again failed to cut rates and seems as if it continues to favour tight monetary conditions, just why I am not sure. Perhaps last week it didn’t wish to merely be seen to follow the lead of the US, maybe we may see an unscheduled move but I am not holding my breath. Chinese authorities are at least considering lifting major restrictions on home purchases after earlier measures failed to revive the struggling housing market. Officials are working on a proposal to allow non-local buyers in large cities like Shanghai and Beijing, who don’t have a so-called Hukou residence permit to purchase homes—a step smaller cities have already taken. Additionally, the government may end the distinction between first- and second-home purchases, allowing for smaller down payments and lower mortgage rates on second homes.

It would seem that for the moment their policy relies on fiscal tinkering but something has to be done to reverse a housing market slump that has dragged on for four years, slowing the economy and causing job losses. Major banks like UBS and Bank of America expect China will miss its 5% growth target for the year. While these new proposals could benefit larger cities, experts say more needs to be done, such as urging local governments to buy unsold housing units from developers.

Despite several measures aimed at supporting the real estate market, home sales and prices continue to fall, and buyers are waiting for even lower prices. Local governments have been given more flexibility to address the issue, and the State Council has asked officials to continue developing new policies to help absorb excess housing stock. Until we see a signs of a recovery, it will fall on the US to do the heavy lifting for world economic growth a role that until recently traditionally fell on China’s shoulders

Next Week

For the week starting September 23, 2024, several key macroeconomic releases are scheduled:

Global PMI Data (Sept 25): Preliminary manufacturing and services PMIs for major economies like the US, UK, and Eurozone are expected. These reports will provide insights into economic activity and sector performance. The US manufacturing PMI is expected to show a slight rebound, while services are forecasted to remain strong.
US GDP (Sept 25): The third revision of the Q2 GDP will be released, with markets looking for any signs of weakness in the US economy.
US Core PCE Inflation (Sept 27): A critical measure of inflation, this report is expected to show a modest monthly increase, with a year-over-year figure rising slightly due to base effects. This is closely watched by the Federal Reserve for its inflation targeting.
Eurozone Inflation (Sept 27): French inflation data will provide an early indication of aggregate Eurozone inflation trends, with a possible decline expected as oil prices drop.