Starting the Tight Relaxation Policy

Transcription

The Federal Reserve is set to cut interest rates for the first time since the pandemic.

However, it and other central banks are not heading for an easy policy stance.

1) Why we don’t see recession in the future

A rise in the unemployment rate has helped amplify recession fears. We see these fears exaggerated.

Employment is still growing strongly. The unemployment rate is rising not because of layoffs, but because increased immigration has expanded the labor force.

2) Recession prices exaggerated

Markets are pricing in Fed rate cuts as deep as those in previous recessions. We think this is just as far-fetched.

Once immigration normalizes, the economy will not be able to add jobs as quickly as it has been without fueling inflation.

This will prevent the Fed from tapering as deeply as in past cycles, we believe.

3) ECB policy

The European Central Bank cut interest rates again last week.

We see eurozone inflation falling to 2% and staying close to there, giving the ECB more room than the Fed to cut rates.

However, supply constraints make it unlikely that inflation will return to well below 2%, as it was before the pandemic. We see the ECB holding rates well above pre-pandemic levels.

Short-term US Treasury yields fell on expectations for deep Fed rate cuts, so we weighed.

We are neutral on eurozone government bonds and UK gilts as the market price of rate cuts is more in line with our view or may go further.

The Federal Reserve is set to begin cutting interest rates this week after rapid hikes to control inflation. Markets expect the Fed to cut rates sharply — and we think that price tag is overblown. US inflation eased as pandemic disruptions faded and as a temporary boost to the labor force from immigration. We see that inflation remains sticky because loose fiscal policy and the impact of mega-forces, limiting how much the Fed can cut. However, we believe recession fears are overblown and remain overweight US equities.

A recession response is not necessary
The Fed cuts rates in response to past recessions and current prices

markets they were quick to price in rate cuts after the Fed ended its fastest hikes since the 1980s — and priced them out when inflation spooked higher. As the Fed prepares to begin tapering, markets are pricing in cuts as deep as those seen in previous recessions. See diagram. We believe that such expectations are exaggerated. A rise in the unemployment rate has fueled recession fears, but employment is still growing. The unemployment rate is rising not because of layoffs, but because increased immigration has expanded the labor force. Consumer spending retreated to services from goods after the pandemic helped inflation fall from recent highs, allowing the Fed to cut rates. A larger labor force helps reduce service inflation. However, under this new regime, central banks face a sharper trade-off between reducing inflation and protecting growth than during decades of steady growth and inflation.

Cooling inflation is likely temporary. The post-pandemic normalization of expenditure-supply mismatches is largely over, while immigration is likely to return to historical trends. Once it does, the economy will no longer be able to add jobs as quickly as it has been without fueling inflation. Wage growth has slowed, but not enough to suggest that core inflation could fall to the 2% target. Supply constraints from megapowers or structural changes will add to global inflationary pressures. That’s why the Fed and other central banks will keep rates higher for longer. However, short-term US Treasury yields have fallen relative to expectations for deep rate cuts, so we weighed. We remain overweight US stocks, but we’re broadening our AI view beyond tech. Our Midyear Outlook scenarios recognize the low chances of the Fed cutting rates as much as markets expect. That could happen if the Fed sees a cooling job growth as a sign that it has been too slow to react to worsening growth by resuming rapid rate hikes. Risk sentiment could turn sour once it’s clear the Fed won’t cut rates as low as markets expect.

Going global

European Central Bank (ECB) cut rates again last week, even though inflation is above its target for now. We see inflation in the Eurozone falling to 2% and staying close to there, unlike in the US. This is still far from the low inflation of the last decade. But the ECB has tightened policy more than the Fed – even though it has faced weaker economic activity – so it has more room to cut rates, in our view. We are neutral on eurozone government bonds and UK gilts as market prices of rate cuts could go further in our view.

The People’s Bank of China has cut interest rates, but it’s not in the same boat as the Fed. It faces weak consumer demand, excess manufacturing capacity and deflation – based on broad measures of inflation – that could become entrenched. The lack of fiscal and other policy support casts doubt on whether the economy will meet this year’s growth target. Export activity has underpinned growth, so it will be essential to watch for any signs of weakness. China equity valuations are low relative to other regions, but given the challenging macroeconomic outlook, we prefer developed market equities over emerging markets and China.

Our conclusion

The Fed is following in the footsteps of other central banks to cut rates this week. We see that sticky inflation limits how much central banks can cut. We remain overweight US equities and prefer European bonds to US bonds.

Market background

U.S. stocks rose about 4 percent last week, rebounding from their biggest weekly decline in 18 months, as technology helped lead the way as recession fears faded and about future Fed rate cuts. U.S. 10-year Treasury yields hit 15-month lows, settling near 3.66 percent, with markets pricing in 200 basis points of Fed cuts by next June. We think this is overkill and could create more sudden price swings as markets see each other between completely different potential outcomes.

Central bank policy meetings are in the spotlight this week, headlined by the Fed. We expect the Fed to cut interest rates for the first time since the rapid hike launched in 2022. However, the recent decline in US core CPI stalled in August, likely taking a 50 basis point cut in the view our. The BOJ will also be in the spotlight after being a source of market volatility following its last meeting in late July.