What’s in store as the rate cycle turns?

Major Western central banks are finally beginning to cut rates, after battling the worst bout of inflation since the Paul Volcker era¹.

For the best part of the past two years, the US Federal Reserve (Fed) had focused on keeping price pressures under check following the post-Covid surge in demand. Economic growth had proved to be far more resilient than earlier expected. Divergent signals emanating from various data points complicated the efforts of policy makers and markets in getting to grips with the evolving scenario.

The uptick in core inflation in the first quarter further jolted the financial markets, which pushed rate cut prospects to the latter half of 2024. Although strong seasonality in month-on-month inflation data and unreliable seasonal adjustments made the assessment of the progress towards the 2% target quite complex, more basic metrics bear out the emerging trend.

Real rates look restrictive vs neutral interest rate estimate*

We believe the path of disinflation has resumed. Non-seasonally adjusted month-on-month numbers for US Core CPI, since October 2022 show that monthly inflation has come below the same figure reported a year earlier in almost all the months, except for a few exceptions. The usual drivers of inflation have also been largely absent over the past two years, with money supply growth non-existent across major developed markets and commodity and food prices softening.

Jobs market is weakening

The Fed’s preferred measure of inflation is steadily moving towards its 2% target. We have been highlighting the weakness in the jobs market for many months and the rising unemployment rate could be a key reason for the Fed Chair Jerome Powell’s dovish tilt. With inflation softening, the Fed seems to have turned its focus on its other main policy mandate.

The US job market looks less tight today than two years ago. This should support further normalization in wage growth. With productivity running at somewhere between 1.5% and 2%, we would argue current rates of wage growth are conducive to achieving the Fed’s 2% target. Prospects of slack in the jobs market also remove a potential wage-price spiral out of the equation.

Less consumption ahead

Distortions caused by the pandemic spurred demand after the lifting of Covid restrictions. Since there was little to spend on during the contagion, excess household savings had piled up, boosting demand from consumers who account for 70% of US GDP.

However, over the past year, the financial health of consumers has steadily declined. Large retailers have been much less optimistic on their recent earnings conference calls. The gradual increase in delinquency rates for consumer loans is another piece of evidence. Restaurant spending has also softened somewhat year to date. 

Estimates of excess savings, low savings rate, elevated volume of consumer credit, lower income expectations and stagnating retails sales are all showing signs of slowdown.

Focus on high quality assets

Outside the US, the recovery in manufacturing PMIs has already stalled. A mix of higher energy prices, lack of space for additional fiscal spending and eroding competitiveness of goods in relation to China all rule out a resurgence in growth. Adding to all this, the results of the European elections add to uncertainty on the political front. Structural problems in China have not been solved yet.

In the UK, the structure of the mortgage market allowed for a much faster transmission of monetary policy, crimping disposable income and consumption. Job creation has also been much weaker in the UK, where payrolls have now completely stalled since the beginning of the year.

Following Powell’s recent policy pronouncement, the debate in the market has centered around the pace and depth of interest rate cuts. Investors still wonder whether a “soft landing’’, where there is minimal disruption to jobs and the broader, economy is possible, or whether we are primed for a recession.

From our perspective, we believe real interest rates look too high and there is a risk that central banks have to ease even faster than currently priced. That could provide a fillip to fixed income markets, particularly the high-quality segments of the asset class.

¹As the Chairman of the US Fed between 1979 and 1987, Volcker combated soaring inflation through aggressive monetary policy measures

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