- Room for rate cuts has opened as sub-3% inflation and above-5% policy rate don’t sit well together.
- By cutting rates now, the Fed can support the labour market, which has softened a tad.
- But the magnitude of rate cuts priced in by markets looks excessive to us.
- For 200bps+ of rate cuts ahead, recession risks would have to spike. We simply don’t see that.
- Our baseline scenario of 150bps in cuts by the end of 2025 is the most the Fed can do, in our view.
Commentary: Downshifting yield curves
The global economy is showing hardly any signs of slowing down; inflation has eased but is still well-over the 2% target in US and EU, and yet, markets are all set for a series of rate cuts in the near term. This is illustrated vividly by the yield curve downshifts in the US and Singapore over the last four months, with the 2-to-5-year segment of the respective curves moving lower by 100bps. Short of a major economic slowdown or destabilising financial market development, downshifts of this magnitude over such a brief period is highly unusual. We wonder if this is bound to lead to disappointment, and eventual tantrum, among financial market participants.
Sub-3% inflation and above-5% policy rate tend to sit together uncomfortably, so it is understandable that some rate cut is warranted around the need to bring down real interest rates. From the US Federal Reserve’s perspective, its dual mandate entails a close look at the labour market, which has admittedly slowed in recent months. A decrease in real rates could provide consumers and businesses some respite by reducing debt service costs, which may in turn ease concerns about the economy and support hiring decisions.
Nonetheless, contrary to some of our fellow analysts, we don’t find the labour market data particularly alarming. The post-pandemic hiring boom has clearly faded this year, but jobs are still being added, the unemployment rate is 4.2%, real wage is growing in positive terms, and previously-discouraged workers are coming back to the labour force. These are not markers for an economy facing recession risks or in need to major support. The market pricing is over-eager, in our view.
We are pleased to see that inflation has eased this year, paving way for some rate cuts. But we need to see far more evidence of the inflation genie going back inside the 2% bottle. For curves to price in over 200bps in rate cuts over the next 16 months, the US economy has to weaken considerably, and inflation will have to be fall below 2%. We simple don’t see that in the horizon. Our baseline scenario of 150bps in cuts by the end of 2025 is the most the Fed can do, in our view.
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