The cuts are coming. The recent few weeks have seen a change in rhetoric from developed market central bankers, with the hawkish messaging that has dominated much of the past two years finally softening. The market is now looking, not for the last hike, but the first cut.
The drivers of this shift relate primarily to a macro economic environment that is starting to show signs of weakness. Inflation continues to fall, with October’s CPI print in the US coming in at 0% month-on-month (core CPI also came in weaker than expected at 0.2%) and November’s Eurozone CPI falling to 2.4% year-on-year.
In addition to inflation that is steadily moving towards central bank targets, we are also seeing signs of weakness in a very resilient US labour market. Non-farm payroll (for which we get an updated number this Friday), printed at 150k in October, below the 180k expected by the market and less than half September’s print. The unemployment rate has also increased to 3.9% from the recent lows of 3.4%.
It is worth saying that growth in the US remains robust, with third quarter GDP growth printing at 5.2% on an annualised basis. This is, however, expected to slow materially in the fourth quarter, with current forecasts from the Atlanta Federal Reserve pointing to fourth quarter GDP growth of approximately 1%. Europe on the other hand, is, in some areas, most likely already in a recession, with third quarter GDP growth printing at -0.1%, whilst PMIs remain firmly below 50 (the threshold that defines expansion versus contraction).
Whilst the data is not necessarily alarming, and largely in line with our expectations, it does point to a change in the balance of risks the central banks are now facing as they move through this cycle. With inflation close to target in the Eurozone and continuing to move towards target in the US, the need to remain as restrictive lessens, and indeed policy becomes more restrictive the more inflation falls if rates stay steady.
It is therefore no surprise to see the market look through the end of the hiking cycle and towards the next important question: when will the central banks start to cut? For context, short-dated futures are now calling for cuts of approximately 125bps in both the US and the Eurozone next year, with the probability of a first cut continuing to move forward. The market is pricing in a 72% chance of a cut from the Fed by March, and an 88% chance in the Eurozone.
Whilst we do not necessarily expect a cut that quickly, we would not rule it out if economies continue to weaken at the same time inflation moves towards central bank targets. It is important to bear in mind that one of main reasons for economic slowdown is the affects of these materially higher rates that over time become further ingrained into the broader economy. The good news is that the central banks do have complete control over interest rate policy and from these lofty restrictive levels they can cut substantially to revive ailing economies as long at it fits their mandates of either inflation targeting or inflation targeting and full employment. We could soon be in a situation where it is clear that central banks will need to move which is why the markets are becoming confident of cuts around the corner
With cuts on the horizon, and credit yields so attractive, cash is probably not sitting quite as comfortably in money market funds and short-dated government bonds. As this money moves to a ‘yieldier’ home, it should create another positive technical driver for performance.