Central bank Pivot 2.0
Posted 20 September 2024
Central banks dominated the narrative this week. The US Federal Reserve’s (Fed) 50 basis point cut to interest rates was by far the biggest market news, surprising some who expected a smaller move. Investors took the news well, with the S&P 500 reaching new all-time highs in response. Then came the Bank of England’s (BoE) non-decision on Thursday. UK rates were held steady, but Governor Andrew Bailey strongly suggested that they will fall again at the BoE’s November meeting.
Fed dovishness makes sense.
The Fed lowered its benchmark rate to a 4.75-5.0% range, delivering an outsized 50 basis points rather than its usual 25 basis points sized move. As a result, this was portrayed as surprisingly large and a sign that the US economy might be weaker than thought – even though implicit market pricing had already indicated a higher likelihood of a 50 basis point cut in the days leading up to the Fed’s decision. The BoE leaving rates unchanged was similarly expected after its August cut, but markets now expect rates to continue falling in the US, UK and Europe. Interestingly though, the implied pace of cuts is notably quicker in the US (a cut at every Fed meeting into next year) than here.
This might seem strange, since the narrative for years has been about world-leading US growth. It was notable that one Federal Open Markets Committee (FOMC) member voted for a smaller cut – when the FOMC normally votes unanimously. But as we have discussed recently, US wage inflation is now falling quicker than elsewhere and unemployment data over the summer contained some worrying signals. Fed chair Jay Powell said in his post-meeting press conference that the FOMC would have cut at its last meeting, had it known the softer inflation data that was about to follow. The 50bps cut was therefore a ‘catch up’ rather than an omen.
Markets certainly took it that way, and global stocks broke new ground on Thursday. Investors are once again confident that the Fed has pulled off a ‘soft landing’ (taming inflation and lowering rates without a recession) and they are evidently thankful. The US yield curve (plotting bond yields across different maturities – as discussed in our INSIGHT article this week) implies a very steep decline in rates: markets expect US rates to be two whole percentage points lower at the end of next year.
But it might not stay this dovish.
That decline looks a little too steep to be plausible. The Fed updated its ‘dots plot’ (charting where individual FOMC members expect rates to be at points over the next two years) to reflect a lower rate path, and markets expect even lower than that. If markets are right, it would be the steepest rate decline since the early 1980s. On the other hand, rate expectations are constantly updated as new data and insights emerge.
To us and others, the market implied level of decline is implausible, given the strength of the US economy. True, the Fed is more worried about unemployment than other central banks, since it is mandated to promote full employment and not just price stability. But unemployment claims are now falling, having risen over the summer, and Fed cuts will themselves be a crucial growth stimulus. As per usual, bond markets have front-run the Fed’s rate cutting, so lower long-term mortgage rates have improved the property outlook. This is already filtering through into construction activity.
We expect growth to hold up well, which means markets currently seem overconfident about the volume of rate cuts – like they were after last year’s ‘Pivot 1.0’, when they thought cuts would start in January. So, we could see bond yields move back up into the year end – as already started this week. That would remove some support for price-to-earnings valuations. But the flipside of this is that lower rates should support profit growth which supports valuations from the other end. This positive balancing of valuation factors supports a decent outlook for stocks.
The US dollar weakened again after the Fed’s rate cut, which has meant US and global equity markets are a bit below their all-time-highs in Sterling terms (as of Thursday close, it was 1.5% below the all-time high of 15th July). However, If US growth firms into the year-end as expected, the dollar’s slide will likely be halted.
Right now, the biggest ‘policy mistake’ threat is coming from China.
Less noted in the media was the Chinese renminbi’s sharp appreciation after the Fed’s cut. Unlike China’s currency appreciation in August, this was not just against the dollar but against key Asian trading partner currencies. It strengthened even further on Friday, after the People’s Bank of China (PBoC) unexpectedly left its loan prime rate unchanged – when even the best informed were expecting a cut.
This strength was clearly because US monetary policy has become more supportive, while China’s has stayed restrictive. But China’s tight monetary policy makes little economic sense, given the weakness of its domestic economy and its overproduction of goods. A former PBoC governor recently argued that Beijing needs to seriously address its deflation problem, and markets thought that the Fed’s big cut would allow the PBoC to loosen financial conditions without weakening its own currency too much (which Beijing clearly does not like).
Instead, the PBoC has kept conditions tight – incredibly so, when you look at China’s historically weak recent money supply growth. As the chart below shows, M1’s contraction is noteworthy (M1 is a widely accepted measure of monetary liquidity within an economy).
It is becoming increasingly clear that Beijing has a bias towards tight borrowing conditions and is willing to let domestic demand suffer in response. That has pros and cons for the world. The upside is that China will keep exporting disinflation to the rest of the world, keeping a lid on global inflation and giving central banks more wiggle room.
The downside is that we cannot expect any global growth impetus from China. It is the world’s second-largest economy and for many years it was the biggest contributor to global growth. But today, Mercedes issued a profit warning citing poor Chinese demand. The country’s current weakness is already a headwind, and it could get worryingly worse if Beijing continues to be so conservative. We see few signs at the moment that it will change, but we will have to watch China’s policy developments closely, given its fraught political history.