We can now safely assume that the major economies' interest rates are on a declining path, except for Japan. The Swiss National Bank has already cut twice, the ECB and Bank of England have inaugurated the process and the FED has signaled that it will do so, in less than a month from now. The Swedish Central Bank (Riksbank, the oldest in the world, founded in 1668) cut rates last week and became the first to commit itself to 2-3 more rate cuts before year end, with its president admitting "we can now say that the economy is pretty much in recession". It was just a few months ago that he still had his "hawkish" suite on, claiming that interest rates could be raised further (!) as inflation risks are still high. Now, they seem to be "behind the curve" as we traditionally say in the world of finance, when a central bank has been late to act, amidst a fast deteriorating economy.
The ECB appears to be the first that we can characterize being "behind the curve". Going through the published minutes of the last meeting, it shows the Committee is still concerned that inflation was not slowing sustainably towards their target, as members were afraid that the disinflation process has stalled. In the same way that central banks were late to acknowledge the threat of high inflation, calling it "transitory" for almost two years, they could be making the same mistake now by failing to acknowledge the speed at which the economies are deteriorating. Especially in the Eurozone, we would not be at all surprised if the ECB soon starts slashing rates fast, even with 50bp moves in one meeting, as the region's economic data are dismal.
The FED has also set the ground for a rate cut in September, as minutes of the last meeting showed that "a vast majority of members thought that a September rate cut appears to be appropriate" and several members even discussed a cut at the July meeting. Mr. Powell at the Jackson Hole symposium on Friday cemented this view with the phrase "Time has come for policy to adjust". He cited that risks are now balanced between higher inflation and a deteriorating economy and they have to manage both.
But are rate cuts good for markets or not ? For starters, rate cuts are primarily beneficial to longer term bonds, especially the highest quality. It is for this reason we had been insisting on buying/adding longer duration bonds many months ago, as their prices tend to appreciate significantly when interest rates are coming down. Turning to equities, cutting rates is not a straightforward exercise. To be more specific, central banks usually cut rates when the economy has already slowed down significantly, equity markets have been correcting and they are discounting further deterioration. The rate cuts attempt to put an end to this downward spiral and equities eventually recover. Moving to today however, rate cuts will come at a time that the US economy appears to be "ok" and equity markets are at record highs. These rate cuts can be seen as what we call "an insurance cut", or in other words cutting without really needing it but to make sure that they give little medicine to a not-feeling-so-well person, before he falls into a deeper state and then needs heavy medication or hospitalization.
In the past, "insurance cuts" have worked positively for equity markets. In order to offer some perspective, if we take the case of the US, the current rate of almost 5.5% must be compared to what is considered to be the "neutral rate", ie the interest rate where inflation is anchored and the unemployment is stable. This is now estimated to be at about 3.5%, some argue even at 3%. With this in mind, we see that there is plenty of room for the FED to cut rates in order to "normalize" them to more reasonable levels, and its policy would still be restrictive (above neural rate), if they are still afraid of inflation. The same holds for the ECB, where the neutral rate could be less than 2% and interest rates are at 4%.
However, if rate cuts are a response to an imminent recession then the equity markets will correct significantly. That was the case in the bear market of 2000-2003 where equities were correcting precipitously as the FED was cutting rates. And during the 2008 financial crisis we had a similar situation when the final 100bp (!) rate cut was in December 2008 and markets bottomed three months later.
The Eurozone PMIs picked up in August, after declines in June and July, but the underlying dynamics remained weak. The Composite PMI rose by 1 point to a 3-month high of 51.2, with the Services PMI up by 1.4 points to 53.3, mainly thanks to strong services activity in France (PMI Services 55 vs 50.3 in the previous month). It seems that the summer Olympics have impacted the French services sector very positively, as it would have been expected. But this should be seen as a "one-off" event. Eurozone's Manufacturing PMI fell by another 0.2 points to an 8-month low of 45.6. Looking at country details , we highlight the German Composite PMI which dropped by 0.6 points to a five-month low of 48.5, with the Manufacturing and the Services PMI both declining by 1.1 points to 42.1 and 51.4, respectively. These data are consistent with a very high risk of a recession (with Germany already in it) and do not warrant interest rates of 4%, at the ECB level.
European and US equities added 1.5% on average last week, in a rather volatile fashion. US Small capitalization companies (Russell 2000) rallied by 3.2%, as the market wisdom says that when a central bank cuts rates one should be buying the most economic sensitive sectors (cyclicals) and smaller, riskier companies. Of course, in the case that the US economy does not finally avoid recession despite the "insurance cuts" these sectors and small caps will sell-off to new lows and only when rates are cut aggressively they will start their recovery again from a much lower base.
The dollar was the main victim of the new regime (ie FED finally starting to cut rates). The big interest rate differential between the USD and other currencies in the last two years had been a primary catalyst for the rally of the American currency. With this differential shrinking, investors/traders are selling it and the EURUSD has touched again 1.1200, which was the high of last year. The Japanese Yen has been appreciating too, but this time it seems that most leveraged short positions have been closed during the early August episode and could create less damage in the markets.
Chart of the Week : The US government is paying 3% of its GDP on interest payments. Not sustainable.
The above chart shows the net interest payments as a percentage of the GDP, of the US government. These have now reached 3% and are climbing. Currently, interest payments are 20% of the government's total revenues. The combination of the explosive growth of US debt in recent years and the much higher interest rates has brought the fiscal situation to levels which are clearly unsustainable. The upcoming reduction of interest rates by the FED will have some positive impact, but this will take time to feed in and affect the total numbers. The clear risk is that the new US government will have to reduce spending or increase revenue (taxes primarily) or both. Both actions could have a negative impact on the already slowing economy and the equity market. This is perhaps more of a 2025 story and highly dependent on who is going to be elected.
Disclaimer
• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.
• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.
• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.
• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.
• Sources: Chart of the Week : FactSet/KSH , Photo vecteezy.com
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