The Fed has officially kicked off an easing cycle with a jumbo 50 basis point rate cut, well above the 25 bp cut expected by financial markets.
While the decision was not unanimous with a dissent within the committee for the first time since 2005, chair Jerome Powell said the economy is “basically fine,” the labour market is in “solid shape” and the unemployment rate is “very healthy”.
Quashing rumours of a weakening US economy, Powell framed the rate cut as a sign of growing confidence in controlling inflation, a safeguard against job losses, and a bold commitment to ensuring the Fed does not “fall behind the curve”.
The Fed’s goal moving forward, he said, is to keep inflation stable while ensuring jobless rates don’t tick up.
Although widely anticipated for September, the Fed’s first rate cut in years has sparked intense debate, with only 1 in 10 economists surveyed by Bloomberg correctly predicting the 50 basis point move. Most Fed watchers had believed the economy’s ongoing strength warranted just a 25 basis point cut.
For Seema Shah, chief global strategist at Principal Asset Management, the Fed’s decision to go big is “a unique move in history”.
“No financial crisis brewing, no asset price bubble bursting, no job losses, and an equity market that was already up some 18 per cent year-to-date. Powell’s positive read of the economy makes the decision even more confounding,” she said.
“Yet, from an investor perspective, the key takeaway from today’s decision is that this Fed will go to historic lengths to avoid a hard landing. With a sequence of rate cuts on the way, recession risk has collapsed.”
Suggestions are that the Federal Open Market Committee (FOMC) will cut a further 50 bps between now and year-end, and a further 100 bps in 2025, before making a final half-point move in 2026 to take the rate to between 2.75 and 3 per cent.
Yet, Powell highlighted the Fed’s agility, making it clear that if the economy stays resilient or inflation remains sticky, they’ll take a more cautious approach to rate cuts.
Additionally, he added: “Intuitively, most – many, many people anyway – would say we are probably not going back to that era where there were trillions of dollars of sovereign bonds trading at negative rates, long-term bonds trading at negative rates.”
Financial markets initially responded to the FOMC decision with a cautious uptick in risk appetite – the bond curve steepened as two-year yields dipped and 10-year yields edged higher, while equities saw a moderate rally.
However, as the day unfolded, the curve steepening continued while two-year yields and equity markets both surrendered their early gains.
Addressing these market shifts, GSFM investment specialist Stephen Miller pointed to lingering inflation concerns and the looming challenges posed by the “gargantuan” US budget deficit. He emphasised the lack of any concrete plans from both political parties to tackle its far-reaching consequences.
“This raises the question whether bond yields can rally substantially further – certainly longer tenor bond yields – despite the Fed being in easing mode, as markets suffer from indigestion associated with the requirements of funding those deficits through record bond issuance,” Miller said.
“It might also be said that markets are currently pricing a very benign scenario and not only might markets be vulnerable to negative risks but have got to a place where they are hard-pressed to price further good news.”
Looking ahead, Shah views the diminished risk of recession as a promising sign for risk assets.
“History suggests that the Fed’s success in piloting a soft versus hard landing will play a key role in dictating the path for US equities. During easing cycles where recession has been avoided and, as a result, earnings growth remains fairly robust, equity markets generally react positively,” she said.
“Since 1985, five of the best 10 years for the S&P 500 came when the Fed was cutting interest rates without recession. The historical perspective should provide investors some optimism for the future of the market.”
Chris Galipeau, senior market strategist with the Franklin Templeton Institute, agreed that history indicates an upcoming strong run for the S&P 500.
“History tells us that when the Fed cuts rates in an economic expansion, that the S&P 500 rallies an average of 16.66 per cent in the 12 months post the initial rate cut,” Galipeau said.
“Since 1990, when the Fed is cutting rates, large-cap growth and small-cap growth generate the strongest performance in the 12 months post the initial rate cut.
“As a result, we view any pullback as a buying opportunity.”
Could the Fed inspire the RBA?
The government swiftly dampened speculation about a similar move by the Reserve Bank next week.
Speaking to media on Thursday, Treasurer Jim Chalmers said: “It’s really important to remember that rates went up by more in the US than they did in Australia and even after this interest rate cut overnight in the US, interest rates are still higher in the US than they are here.
“When the Reserve Bank meets next week, they will consider a whole range of things including that, but they’ll be primarily focused on inflation, as the government is.”
Also making the media rounds on Thursday, Prime Minister Anthony Albanese remarked that the US is cutting rates due to a sluggish economy.
“Inflation peaked higher in the United States and interest rates peaked higher in the United States than they did here. They’re cutting off a higher rate. Here, we’re peaked at 4.35.
“In most of the Western world, it exceeded 5 per cent and far above. And that is what they were dealing with after – in places like the UK, we had inflation which was double digit. So, what we have done is attempt to manage the economy in a way that looked after people on the way through.”
Chalmers and Albanese weren’t the only ones tempering expectations of the RBA mirroring the Fed’s rate cuts. Traders also scaled back their rate cut forecasts, with bond markets now pricing in a 79 per cent chance of a cut by Christmas, down from 85 per cent on Wednesday.
Currently, markets are assigning only a 10 per cent likelihood to a rate cut at next week’s RBA meeting.
