We can’t fight the Fed. We can’t listen to it either. Welcome to the old normal.

The world’s most important central bank, and purveyor of the global reserve currency, is the most important x-factor for financial markets. Over the long term, earnings and economic growth will always drive valuations. But over the shorter term, markets care mostly about the cost of money, primarily the US Dollar. Where the Fed goes, the central banks of America’s biggest trade partners are compelled to follow.

Aiming to restore faith in markets after the collapse of Lehman Brothers in 2008, the Fed began to communicate its intentions clearly and well ahead of schedule. A market so nervous and volatile in the wake of the global financial crisis needed no surprises.

But there’s a toll in over-communicating. A whole generation of traders has learned to rely on that. Analysts have Fed-watched for over 15 years. Every word of every official is dissected analysed and fed into a mental or even a quantitative model. The Fed has often used this to its advantage, as it could ‘talk’ rates up and down, well before having to move on them. ‘Forward guidance’ was a useful tool, as it could move long and short-term yields quickly without having to make policy decisions and reduce volatility.

Inflation, however, began to upend this. A notoriously erratic macroeconomic variable, it has gradually turned the Fed more unpredictable in the past few years. Throughout the latest rate tightening cycle, the Fed delivered much sharper hikes than markets anticipated. Last week the Federal Open Markets Committee, the Fed’s rate-setting body, decided to reduce interest rates by a half percentage point. While traders buying bonds en masse ahead of the cut gave credibility to the narrative that ‘the market was positioned for it’, it was really not the case. Only nine out of 113 economists interviewed by Bloomberg believed that a ‘jumbo cut’ was coming. Equity markets rallied after the event and bond yields plunged further. In terms of impact, it is estimated that for the next few months, this will affect no more than 5% of Americans whose loans, or whose business loans, are up for renewal.

To be sure, we never really know what the market is collectively ‘thinking’. ‘Implied expectations’ is a technical measure of bond futures, suggesting where the rate should be to justify current pricing. A narrative is created, to be sure, on the back of it, but it is by and large an exaggerated one. Saying that “markets expect higher/lower rates” as a result of a futures curve calculation is the equivalent of saying that “markets are expecting higher earnings” after an equity rally.

Now that we have established that the Fed didn’t do what the markets expected, let’s focus on what it said:

The Fed told us a number of things last week, along with the jumbo cut, which taken together don’t necessarily match:

• That economic growth is solid, BUT it worries about the jobs market.
• That inflation has been beaten, BUT that this cut is an adjustment and we should not discount further such cuts.

The narrative of strong growth and inflation under control does still justify rate cuts, to be sure. What it does not justify is the shift in the dot plot, the Fed’s unofficial internal survey, which saw one cut by the end of the year just six weeks previously, and now sees four.

There are thus three alternatives:

1. The Fed is right and the data justify a jumbo cut.
2. The Fed sees risks of recession or something breaking in the market that investors are not pricing in. Or;
3. The move was simply political.

Let us examine them.

(1) In a previous note, we said we didn’t see the urgency for big rate cuts. That conclusion still stands. Labour data have been revised down, to be sure, but it has often been noted that the uptick in unemployment (at 4.2% improved from the previous month’s 4.3%, it is significantly below the average of 5.7%) is mostly a supply issue. Meanwhile growth, as economists and the Fed tell us, is robust enough, expected to at 2.5% average in 2024 (albeit slowing to 1.8% in Q4). Inflation has been coming down, to be sure, but mostly because of goods, the result of China’s overcapacity deflating certain parts of the inflation basket. Services inflation remains too high for comfort. So the data we have in front of us doesn’t justify the urgency. It is important to say that the ECB and the BoE didn’t echo the Fed’s victory lap against inflation.

(2) The Fed sees risks that we (the market) do not. This is entirely possible. But it is very difficult to do a double cut and say “It’s all good, don’t worry about it”, while a recession narrative is building.

JP Morgan’s Jamie Dimon reiterated his view that he’s sceptical about the ‘soft landing’ narrative after the double cut. Even if that is not the case, the fact that the Fed didn’t make a solid case for the double cut, while at the same time keeping growth projections highs (a nearly impossible feat) now leaves room for doubt.

(3) While we would often prefer to live in a West Wing type of world, where institutions respect each other’s boundaries and collectively conscientiously work for the improvement of citizen’s lives, our shared reality more often resembles the House of Cards, where transactions take place in silent corridors of power. A political move would explain Michelle Bowman’s first board dissent in nearly two decades. After all, there is significant political value for the incumbent government to be able to declare a win on inflation and growth at the same time just six weeks before an election while boasting an all-time high stock market.

What it means for investors

The reality is, a few days after the double cut, we are none the wiser about what the Fed is going to do next. And while the US central bank may prefer it that way, as investors we need to think what this means for our portfolios.

To be sure, we can still safely assume that the important functions of the Fed are still there:

• The ‘Fed Put’ an unspoken promise to calm markets when volatility surges and throw money at serious issues when they arise is still in effect.
• It will still be a lender of the last resort to good borrowers.
• An inflation fighter.
• A steward of growth (through its unemployment mandate).

But where those targets compete (around turning points for inflation and growth) we simply don’t know what they will do. As it chose not to warn investors of its intentions, it means there’s no need to monitor every word in future, as opinions may simply change. The bond market is currently pricing in three more cuts until the end of the year, one more than what the Fed itself now predicts. It matters not. The Fed may again change its mind.

So, what can we do? We need to stop trying to position for the Fed’s next moves, and instead focus on what we do know:

• Macroeconomic data (growth, inflation, jobs, money velocity etc) for the bond markets
• Earnings and momentum for the equity markets
• The US Dollar and demand conditions for gold (supply is more or less stable)

We have often said that the US central bank has strived towards a world where its role is more limited to its core functions and less ‘guiding the markets’. An old normal, of sorts, the kind investors used to experience before the ascent of Alan Greenspan and Ben Bernanke’s expansive monetary policy.

This may just be it.

George Lagarias – Chief Economist

Market Update

All eyes were on the US Federal Reserve last week, as it cut interest rates for the first time in over four years. The 0.5% rate cut was larger than expected by a majority of economists interviewed by Bloomberg; consensus estimates were for a 0.25% cut. Equities whipsawed immediately following the news. US stocks initially sold off on Wednesday afternoon, but quickly recovered in after-hours trading, and by Thursday afternoon had climbed to an all-time high. The rally following the Fed decision was broad based, with most sectors taking part, and information technology seeing the largest returns. US equities were up by +1.4% in US Dollar terms over the full week.

Returns were diminished in GBP terms as the Pound strengthened versus other currencies after the Bank of England held interest rates steady at its rate-setting meeting on Thursday. Sterling rose by +1.5% versus the US Dollar, +0.7% versus the Euro and +3.7% versus the Japanese Yen. In Sterling terms, US stocks fell by -0.1%, EU stocks fell by -0.9% and Japanese stocks fell by -0.8%.

10-year government bond yields rose modestly as yield curves steepened following the Federal Reserve’s decision. US, UK and German 10-year yields rose by +8, +13 and +7 basis points respectively over the week.

Macro news

UK retail sales volumes rose by 1.0% month-on-month in August (above expectations of 0.4%), after an increase of 0.7% in July. On a year-on-year basis, sales rose by 2.5%, the largest annual increase since February 2022.  Most retail sectors posted higher sales: among the best performers were clothing and footwear (+2.9% MoM) and food stores (+1.8%). Warmer weather, end-of-season sales and higher purchasing power were the main factors behind the higher sales volumes.

The US Federal Reserve cut its benchmark interest rate by 0.5% on Wednesday and signalled more reductions would follow, launching its first easing cycle since the onset of the pandemic. The significant policy shift was widely expected, given growing signs that the central bank has managed to cool inflation without severe harm to the economy. In the latest summary of economic projections, Fed officials expected the policy rate would fall to 4.5% by the end of 2024, suggesting two 0.25% reductions in the two remaining meetings this year.

In contrast to its US counterpart, the Bank of England kept interest rates on hold in September. Likely as a result of still stubborn services and core inflation in August. Inflation data released this week showed that UK headline CPI inflation remained at 2.2% in August. Core inflation, which strips out volatile energy and inflationary items, rose from 3.3% to 3.6%. We expect the Bank of England to pick up the pace of rate cuts over the next few meetings, as both the US and the ECB are on a steeper rate cut cycle and there are signs that UK inflation is under control.

The week ahead

In the US, durable goods orders and core PCE (the Federal Reserve’s preferred measure of inflation) will be released this week. Elsewhere, flash PMI data for regions including the UK, US and EU will come out this week.