This article was written by Attila Kadikoy and published on 24 October 2024 on BusinessDay.
There is market talk of a no-landing, rather than a hard or soft landing, in the US economy.
There has been a wave of positive sentiment since the US Federal Reserve’s cut of 50 basis points (bps) at its September meeting. But that doesn’t mean interest rates will come down to previous levels or that there will be a sudden drop.
In fact, the Fed’s cut in September was a pre-emptive move intended to ring-fence the risk of a downturn after having seen the labour market softening and earnings of small to medium-sized businesses coming under pressure. The extent of the cut surprised most market participants, who had predominantly factored in a 25bps rate cut as their base case.
The ensuing optimism prompted markets to price in interest rate cuts of about 200bps in late September. After this, yields softened significantly. But will there be cuts of 200bps? I argue that this is unlikely, and cutting rates to this extent would be unfounded based on previous interest rate levels and from a liquidity point of view.
It is too early to tell the extent of likely rate cuts because inflation must remain low.
The Fed must also see evidence of a slowing economy and deteriorating labour market conditions to reduce interest rates by another 50bps at the next meeting. The latest jobs data has reduced the likelihood of a hoped-for November half-percentage point cut, denting market expectations on the extent of likely rate cuts in the year ahead.
US jobs data shows payrolls rose by an unexpected 250,000, the unemployment rate fell to 4.1%, and annual wage growth rose 4%, its fastest pace since May after falling promisingly this year so far. These figures are a keen reminder that continued rate cuts are not guaranteed. They also prompted renewed market talk of a no-landing, rather than a hard or soft landing, in the economy, a scenario characterised by strong growth and inflation continuing to run ahead of the Fed’s target range.
Morningstar senior US economist Preston Caldwell says the September jobs report means the Fed is “almost certain” to cut by 25bps rather than 50bps at its next meeting. “Overall, the report takes some of the edge off the jobs data, which had previously shown an alarming uptick in unemployment and decelerating nonfarm payroll employment growth. We’re unsurprised that the jobs data has veered in a more positive direction.”
He says it would be surprising for the labour market to lurch off a cliff even while economic activity grew robustly, and notes that the labour market is almost always a lagging indicator.
RBC Wealth Management senior fixed-income strategist Thomas Garretson also cautions against expecting further “supersized rate cuts”, saying the downside risks for the US economy have not entirely disappeared. He notes: “Markets are pricing in a swift return towards more neutral levels – that is to say, levels that are neither restrictive nor stimulative for economic growth and inflation – which the Fed now judges to be somewhere around 3%, still a historically elevated level.”
Geopolitics makes it even more challenging to pin down the most likely interest rate end game
Oil prices are leaping in the wake of Iran’s missile attack on Israel and Israel upping the ante in its war against Hezbollah in Lebanon. It is difficult to predict whether there will be a widespread Middle Eastern war that fundamentally affects the global economy and underpins higher commodity prices.
An empty barrel makes more noise than a full barrel. I don’t believe geopolitical tensions will have much of a global economic impact because countries in the Middle East don’t want the hostilities to go too far. While Iran may engage in sabre-rattling, it doesn’t have the military might to engage in full-on warfare with Israel. Also, its most important priority is protecting the regime, and direct conflict could create internal strife and threaten this. Saudi Arabia is pro-US and highly unlikely to go against the world’s leading economy. The kingdom will be pleased to see its regional rival Iran on the back foot.
However, geopolitics will inevitably affect investor sentiment and macroeconomic expectations.
While the short-term outlook for inflation and interest rates is essential, it is crucial to remember that the developed world economies are experiencing a paradigm shift. Since 2008, monetary policy became expansive and released significant liquidity into the system over the following 14 years, resulting in near-zero interest rates. That means Netflix, Tesla and Amazon could expand their borrowing significantly without adversely affecting cash flow. Rather than issue new stock, they would borrow at nearly zero percent.
I believe that era is over. Now there is an actual cost to borrowing as interest rates normalise, and there is no longer a reason to pump up liquidity or reduce interest rates back to zero. The big question is where long-term interest rates are going to settle. I believe the 10-year treasury yield is likely to trade at a 75-100bps premium to the inflation rate, which means if inflation runs at 2.5%, the benchmark bond yield will trade at 3.5%, and if inflation falls to the central bank’s 2% target it will trade at 3%.
That isn’t a substantial drop from the 10-year treasury yield’s mid-September low of 3.6% before it sold off to about 4% due to the shift in interest rate expectations in the wake of the buoyant job market data. So investors will be better off focusing on this long-term picture, ignoring the short-term noise and basing decisions on an interest rate outlook that doesn’t chop and change based on the latest economic data.
Kadikoy is a partner with Levantine & Co Investment Management.
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