Last night the US Federal Reserve’s interest rate setting committee delivered its long-anticipated rate cut, reducing the Fed Funds rate by 50 basis points to a 4.875% target range. As we’ve been arguing, the Fed should have eased at its July meeting, so the 50-basis point reduction was the Fed in effect playing catch up.
Elsewhere, the committee’s forecast of the degree to which it will reduce interest rates over the next two years (median dot plot chart) fell by 75 basis points compared with July, and it now expects Fed Funds to fall to 3.375% by the end of 2025 and 2.875% by the end of 2026. We feel that the expectation of the level of Fed Funds over the longer term is reasonable, but that there is scope for interest rates to be lower than the Fed expects next year – which echoes current market expectations.
To tease out what all this means for markets we must consider recent developments in the US government bond market. For the two-year period up to last month, the interest rate (or yield) on bonds maturing in ten years’ time was lower than bonds with a maturity of two years.
This phenomenon is what investment professionals call a “yield curve inversion” and is at odds with the positive interest rate differential usually witnessed between short-term and long-term bonds (investors usually require a higher return for lending for a longer period).
The principal reason for a yield curve inversion is that investors expect interest rates to fall over time. However, its relevance for the economic outlook lies in the fact that recessions have invariably followed periods of time when long-term interest rates are lower than shorter-term rates.
Many investors have therefore concluded that the US government bond market is sending a strong signal that the US economy will enter a recession in the months ahead, even as the Fed cuts interest rates to cushion any future weakness in US economic activity and the interest rate differential between short-dated and long-term bonds turns positive once more.
Over recent years central banks have been active participants in bond markets, buying up huge swathes of securities to lower market interest rates and increase the money available for banks to lend. In our view this has distorted the relationship between bonds of different maturities and makes it a much less reliable predictor of future economic conditions.
Furthermore, recessions usually occur when we see a sudden change in the behaviour of companies and consumers caused by an adverse shock. Many in the market feel that the earlier 5% increase in Fed Funds between April 2022 and July 2023 represents such a shock. We take issue with this point. The effect of higher interest rates on households proved less severe as borrowers had already locked in low mortgage rates. Elsewhere, household and corporate balance sheets proved more resilient as wage growth and corporate earnings have been robust. Finally, inflation has fallen more rapidly than expected this year and is likely to cool further in the months ahead.
We expect growth to moderate further over the next twelve months and inflation is likely to cool further going into year end. However, the resilience of the household and corporate sectors, the magnitude of rate cuts we are likely to see, and the fact that the bear case seems to be consensus, all support a constructive stance on equity markets as we head into year end.
