Fed pivot on the horizon

Given the signals and tone of the Fed, it is likely that the FFR will be cut by 50 bps this year. — Reuters

SINCE the start of the year, the US Federal Reserve’s (Fed) rate cut expectations have been a guessing game for the longest time as the Fed has maintained the current rate of between 5.25% and 5.50% for the past 12 months and counting.

The last rate hike of 25 basis points (bps) took the US Fed Fund Rate (FFR) to its highest level since 2001, bringing the cumulative interest rate increase to 5.25% from the floor level of 0.00% to 0.25%, carried out over a period of 16 months.

Although the market has been betting on a rate cut for a while now, the stubbornness and stickiness of core inflation prints and the relatively strong labour market have left the Fed holding out US key interest rates relatively higher against its global peers and most importantly, for a longer period.

Recent monthly economic data are beginning to show weakness in the US economy. First, the labour market has softened as the unemployment rate has surged to 4.1% – which is the level last seen in November 2021.

Second, while non-farm payrolls (NFP) are still sustained at a relatively high level of more than 200,000, the revision for past months is a worrying trend as the underlying strength of the labour market is in essence relatively weak.

For the past five months and based on the second reading, the January-May NFP has been revised down by 181,000, and based on the third reading, the January-April NFP has been revised down by 196,000.

Third, hourly earnings pace of increase at just 3.9% year-on-year (y-o-y) in June 2024 was the slowest since May 2021 and well off the peak growth rate of 6% last seen in March 2022.

Besides the labour market, the Fed’s key objective of keeping the FFR higher and longer was to tackle the sticky inflation prints with a focus on the core personal consumption expenditure (PCE).

The latest data for May 2024 showed that the core barometer has now dropped at a pace of just 2.6% y-o-y, the slowest rate of increase since the 2% y-o-y growth seen in March 2021, and well in line with the Fed’s core PCE target of the same for this year.

Inflation moderating

Other indicators also show inflation has moderated but not as fast as the Fed would like, with the latest June 2024 consumer price index (CPI) and core CPI at 3.0% and 3.3% y-o-y, respectively, which is the lowest prints in more than four years.

In addition, the headline CPI is well off the highs of 9.1% y-o-y growth in July 2022, while core CPI has been halved from the high of 6.6% y-o-y increase witnessed in October 2022. Interestingly, on a month-on-month basis, the headline June CPI fell for the first time since May 2020.

Economists all over believed the Fed would be able to manoeuvre a soft-landing scenario for the US economy and avoid a recession.

As of now, the US economy remains relatively strong with the final first-quarter gross domestic product (GDP) data showing that the US economy expanded at a 1.4% annualised rate and 2.9% on a y-o-y basis.

Although not in recession yet, the Fed’s rate cut move will be crucial as failure to act before the economy gets even weaker would suggest a hard landing for the US economy and along with it, the pain that comes with it to US consumers as well as businesses.

As it is, the US yield curve has been inverted for the past two years, with the two-year US treasuries trading at 30 bps higher than the 10-year papers.

Based on historical trends, an inverted yield curve is a signal of a looming recession within the next 12 to 18 months but for now, that is yet to occur, even after 24 months.

According to the World Bank and the International Monetary Fund, the US economy is expected to maintain a positive growth of 2.5% and 2.6%, respectively. However, the US economy is beginning to see some softening data points.

Key weakness was seen in the Institute for Supply Management (ISM) purchasing managers index (PMI), with the services PMI and manufacturing PMI dipping below the neutral 50-point mark and at just 48.8 and 48.5, respectively. A reading below 50 signals contraction in the two main components of the US economy.

What is also worrying is that the ISM services PMI reading is the lowest level for the index since April 2022 while the ISM manufacturing PMI dipped for the third consecutive month.

Rate cuts

In the June 2024 Federal Open Market Committee meeting, the Fed signalled one rate cut for this year and the market too had adjusted to the expectations of a similar movement.

However, given the weakness in economic data points, especially from the US labour market and tame inflation prints, the market has raised the odds with the market now seeing two rate cuts this year – in the September and November 2024 meetings, while a third rate cut of 25 bps in December has been assigned a 43% probability.

With the expected 50 bps cut (and excluding the likelihood of a December rate cut), the FFR rate will end the year at 4.75% to 5%.

Among the G7 countries, the Bank of Canada cut its benchmark rate by 25 bps while the European Central Bank (ECB) lowered its rate by a similar margin in June as well.

With rising unemployment in Canada, the central bank is expected to cut rates again this month, followed by another two rate cuts within the next three meeting dates, based on market estimates.

As for the ECB, the next 25-bps cut is baked-in but further rate cuts would likely depend on key economic data points, especially if inflation is on a steady path to a slower growth towards its target of a 2% increase.

Outside the G7 and among other major developed economies, the Reserve Bank of Australia (RBA) looks set to resume rate hikes with the possibility of the cash rate by up to 25 bps this year to hit 4.6%.

The RBA, despite leaving rates unchanged since November last year, is poised to raise rates in its fight against sustained inflationary pressure, which increased by 4% y-o-y in May and highest since the November 2023 print of 4.3%.

Typically, rate cuts are positive for both the equity and fixed-income market, provided it is done at an appropriate time and not when a recession is clearly on the horizon and consumer and business confidence has collapsed.

Given the signals and tone of the Fed, it is likely that the FFR will be cut by 50 bps this year and well ahead of poor economic data points as the Fed is seen to be able to contain a hard-landing scenario.

Given the above parameters, the US yield curve will likely bull-steepen eventually as short-term rates will drop much faster than the longer end but the current inverted yield curve may only normalise when the market sees a more profound and aggressive cut, especially in 2025.

Pankaj C. Kumar is a long-time investment analyst. The views expressed here are the writer’s own.