Nailing the Descent
Nailing the
Descent
It’s been over 2 years since the US started raising interest rates in response to the post-pandemic inflation shock. Next week they will almost certainly begin the descent and start cutting rates. Will they nail a soft landing, bringing inflation under control without crashing the economy? Or have they left it too late and is the world’s largest economy heading for recession?
Having cut interest rates to almost zero (0.25%) during the pandemic, the US Federal Reserve (Fed) eventually started raising interest rates in February 2022 with inflation at nearly 8%. 16 months later interest rates topped out at 5.5% by which time inflation had fallen to 3%, albeit core inflation (which strips out food and energy) was still running hot at around 5%. Since then, even as both headline and core inflation have closed in on their 2% inflation target and other central banks have started cutting rates, the Fed has held steady.
Market expectations are that once they start the Fed will cut rates aggressively over the next 18 months. Current market expectations are that they will cut rates cumulatively by 2.5 percentage points from 5.5% to 3% by the end of next year – almost halving interest rates. The size and speed of expected cuts are more consistent with a recession than a soft landing, whereas other market indicators, such as credit spreads or equity valuations, are more sanguine about recessionary risks.
The Fed is expected to cut interest rates aggressively over the next year, a level of response normally reserved for recessions
Source: Artorius, Bloomberg
So, is a recession likely or have market expectations become untethered from reality? The US economy is undoubtedly slowing down: employment growth is slowing sharply (as shown in the chart below), unemployment is rising, the housing market remains in the doldrums and the manufacturing sector, which seemed to be recovering, is again heading down. However, the dominant service sector remains in rude health and the US economy is expected to grow by 2.5% this year and 1.7% in 2025, which while lower is still better than in Europe (both the UK and Eurozone are expected to grow by 1.3%), albeit the growth gap between the regions is closing.
Nevertheless, a US slowdown is of concern. It may be trite but the saying “if America sneezes, the world catches a cold” still holds true. If the US slowdown proves worse than expected it will have an impact globally and will test asset valuations. However, from next week interest rates will be falling in all major economies (except Japan, which we’ve covered in other notes) providing succour to those reliant on borrowing, from home buyers to smaller businesses, and will, over time, support the economy. The only question is whether central banks have timed this well and will manage to pull off a soft landing. They were arguably too slow in responding as inflation rose and it remains to be seen if they have left it too long in changing course.
Other central banks have already started cutting interest rates, Canada leading the way with 3 cuts, while the ECB (European Central Bank) cut rates for a second time this week. In the UK the Bank of England has cut once and two more are expected by the end of the year.
Employment growth is slowing sharply and unemployment is rising (albeit from a low base)
Source: Artorius, Bloomberg
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The truth about cats and dogs
The first US Presidential debate ultimately led to Joe Biden dropping out (or being forced out) of the election after a stuttering performance. The second debate this week, while nowhere near as dramatic, may still have a major impact on the upcoming election. From eating cats and dogs to worrying about the size of his rally, there was no new information gleaned about Donald Trump in the US Presidential debate. Whereas for many, despite being Vice President, they may not have known that much about Kamala Harris. The general consensus is that her performance beat expectations and has given her campaign renewed momentum (betting odds on her to win certainly narrowed; it remains to be seen whether it will lead to further gains in the polls). However, elections are not won in the debates and neither are they won by the popular vote, otherwise Hilary Clinton not Donald Trump would have become President in 2016. Ultimately a small number of voters in the swing states will decide this election and with only 7 weeks to go the race is too close to call.
Gareth Thomas
Head of Investment Management
Important Information
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