The cuts are coming! But how many and how fast?

Thus, when the Fed speaks next week it is widely expected to perform its first rate cut in this cycle. Last week, a host of US central Bankers (Williams, Bostic, Daly, Waller) all but confirmed that a September cut is imminent. Waller, a hawkish Republican, indicated that he would be willing to support more cuts if and when the data supported it. This is very important for the US economy, the largest single consumer market in the world. Arguably, it is even more important to the Bank of England and the European Central Bank who have already started to cut rates and eagerly await the Fed to begin too, so that they can continue without risking fund outflows due to a wide interest rate differential.

But what is the Fed going to do? There are four possible outcomes of the September meeting:

No cut: This is a low-probability event. At the time of writing, markets are pricing in one to two rate cuts, Fed officials have more or less confirmed that the Fed was ready to start reducing the cost of money. A decision to maintain rates could send risk markets into a tailspin, especially given the volatility of the last few weeks.

Hawkish cut: A hawkish cut is the next possible outcome. The Fed would perform one cut, but communicate firmly that this cut isn’t necessarily the first of many, and it would be closely monitoring inflation data to determine the timing of future cuts. Given the volatility of the past few days, with popular trades such as Nvidia unravelling, this event too could be negative for risk assets. The combination of just one cut and hawkishness would probably go against the current dovish consensus.

One dovish cut: A dovish cut is what is currently mostly priced in. The Fed would cut once but use dovish language to signal that they worry about weakness in the labour market. This event will probably cause some short-term volatility, but we would expect prices to remain roughly where they are.

Double cut: a 0.5% rate cut is what many traders have been positioning for. We don’t think this is a highly likely event, and can’t help but acknowledge that the double-cut narrative has been proliferated by market participants but not the Fed itself. A ‘big cut’ would signal that the Fed is highly anxious about the labour market and that inflation is all but beaten. Should it come to pass, we would expect some short-term positive reaction from markets. However, the long-term signal might be a negative one pushing stocks down. Equity markets are still near all-time highs. The Fed cutting at an express rate may give credence to the narrative of an impending recession. Markets don’t just trade on how expensive money is, but also on profitability prospects. As Wei Li, Chief Global Strategist at Blackrock put it, we are in a market where ‘bad news is bad news’.

Another dimension that should be added to the analysis is quantitative tightening. Already the Fed has quietly reduced average monthly tightening from $91bn to $52bn.

Any specific mention of further cuts in quantitative tightening would add to the ‘dovish’ narrative.

Our house view – slow-paced cuts

Our core assumption is that the Fed will likely cut once in September to get the ball rolling, which is also what markets are roughly positioning for. The question we have yet to answer is whether it will be a dovish or a hawkish cut. We were in the ‘hawkish camp’, but labour market data and recent Fed narrative are balancing the odds.

However, forward market positioning sees two more cuts in November, right after the election, and possibly one or two more cuts in December, for a total of eight cuts by April 2025 and ten cuts by December 2025. Historically, steep rate cuts at the end of the cycle have indeed been the case. This time around, however, we think that there’s no need to cut quickly. Currently, we are in the camp of 2 more cuts in 2024.

As is often the case in this cycle, we think bond markets (from which expectations are implied) are probably getting ahead of themselves. To be sure, while we divine rate expectations from bond market positioning, we need to acknowledge that rates are not the only reason one buys fixed income. In fact, the market right now may be suffering from a case of Fear of Missing Out (FOMO), with traders competing to lock in a yield now while they can find one.

The Fed, however, looks at the economy, which does not paint a distressing picture.

US GDP growth is projected to be 2.5% by the end of 2024 and slow down to 1.7% next year.

Personal spending for American consumers was at its long-term average of 2.7% for the year to July and above its long-term average for the last three months. If anything, numbers have improved since last Spring.

The US services sector, which accounts for more than 75% of the economy, was the second-best performing globally in August.

Economists surveyed by Bloomberg see no more than one in three probability of recession.

The labour market is weakening to be sure, with non-farm payroll data for the past year revised significantly down. However, some of the rising unemployment can be attributed to higher immigration (thus higher demand as opposed to lower supply).

Unemployment actually ticked down from 4.3% to 4.2% in August. The National Federation of Independent Business (NFIB) small business survey, suggests that hiring plans have indeed weakened, but still remain slightly above their long-term average.

On the one had we have two key measures, the Sahm Rule (a measure of the rate of change in unemployment) and yield curve dis-inversion (the difference between the 10 and the 2-year US Treasury) both suggesting a possible recession…

…it is good to be reminded that the Taylor Rule (a key Fed mathematical tool which computes optimal interest rates) suggests that 5.5% interest rates might just be appropriate.

It is also good to be reminded that service inflation remains too high for comfort and that the Fed has carefully avoided declaring victory on the price front.

To be sure, we do agree that US labour conditions are deteriorating and that growth is weakening. The Fed has said so on many occasions in the past few weeks. Underemployment, a key measure for us, has ticked up to 7.9% from 7.4% in June (having said that, it is the gig economy). But we do see this as a cyclical trend, the natural and, by and large, expected result of higher interest rates for a period of time. As rates come down, the economy should balance again.

Where we differ with some wider market expectations is the level of expediency. At present, where others may see ‘rushed’ cuts so that the Fed is able to get ahead of the curve, we see only a ‘paced’ reduction.

Ultimately, the Fed’s choices will make a big difference to the Bank of England and the ECB, both of which are keen to reduce rates earlier, as they have to contend with similar inflation but much lower growth.

George Lagarias – Chief Economist

Global stock markets fell by -3.9% last week as US economic data came in weaker than expected, resurfacing fears over growth prospects. Data for US manufacturing, US job openings and non-farm payroll growth surprised to the downside, stoking concerns over a slowdown in US growth and even a possible recession. Cyclical sectors of the stock market sold off more severly. Information technology was the worst performing sector over the week, while defensive sectors such as consumer staples, utilities and real estate fared better. 

Regional performance mirrored the broader market. US and EU stocks sold off the most heavily in GBP terms, falling by -4.2% and -3.7% respectively. UK and EM stocks fell by -2.3 and -2.2% each. 

Bond yields fell over the week as traders priced a higher probability of a ‘jumbo’ 50 basis point hike at the Fed’s September meeting. US 10-year treasury yields fell by 20 basis points, while UK and German 10-year yields both fell by 12 basis points. Notably, the US yield curve turned ‘dis-inverted’ last week. For the last two years, the yield on 2-year US treasuries has been higher than that of the yield on 10-year treasuries; historically one of the longest periods for which this relationship has held. On Wednesday, this reversed. Historically, disinversions of the US yield curve have been associated with the lowering of interest rates by the Federal Reserve. 

Macro news

After a strong first half of the year, when GDP expanded at an annualised rate of 2.2%, the US economy is showing signs of cooling. This week, the ISM Manufacturing PMI index, a measure of the overall health of the manufacturing sector, showed that industrial activity continued to contract in August. Subcomponents of the index related to employment and new orders were also in contractionary territory. 

In the same vein, labour market indicators signalled a further easing of labour conditions. Job openings fell to their lowest level in more than three years in July and came in below all economist estimates for the period. The US jobs report also disappointed, with 142,000 non-farm payrolls being added in August, below expectations of 160,000. 

Federal funds futures now price in a 30% chance of a 50 basis point rate cut at the Federal Reserve’s September meeting. End year implied rates are consistent with 100 basis points worth of cuts by the end of the year. 
 

The week ahead

All eyes will be on the US inflation report this week, being the final inflation report ahead of the Federal Reserve’s September meeting, where it is widely expected to cut interest rates for the first time in 4 years. The US presidential debate on Tuesday will also be closely watched, with presidential candidates Harris and Trump going head-to-head for the first time on the debate state. Elsewhere, the European Central Bank will make its interest rate decision on Thursday, while UK employment and GDP data will be released on Tuesday and Wednesday respectively.