Are market expectations too high?
Even after the US Federal Reserve lowered its benchmark interest rate by 0.5%, investors are still expecting the Fed to do a lot more over the next 12 months. The chart below shows the implied Fed funds target rate illustrating the levels communicated by Fed members versus the market expectations.
Source: Bloomberg data, as 19.09.2024.
Looking at the longer end of the curve, the US 10-year Treasury yield has dropped significantly, from 4.7% in April to 3.70% currently. This rapid decline is reflective of investors forecasting interest rates to move lower by 0.9% by year-end and by another more than 1% lower in 2025.
Source: Bloomberg data, as 18.09.2024.
This reflects expectations of a sharp Fed pivot in response to potential economic weaknesses.
In our view the economy will remain stronger and not soften quickly enough to warrant a strong Fed response. We anticipate only one more rate cut by year-end, as the US economy, supported by resilient GDP growth and a relatively solid labour market, continues to show strength. Indeed, the US economy, looking at GDP expanded 3.1% in the second quarter year-over-year.
Inflation risk may be higher than recession risk
In our view, the Fed will likely proceed with caution going forward, reducing rates at a slower pace to avoid reigniting inflationary pressures. After all, inflation has been the primary reason for such a rapid and strong interest rate hiking cycle.
Source: Bloomberg data, as 18.09.2024.
In our view, the Fed will likely opt for a more gradual approach, with only two cuts by the end of the year, with its next moves likely driven by the evolving inflation and unemployment data.
What are the timely opportunities?
Investors believing in a still robust US economy sailing through 2025, essentially should be in the camp that markets are pricing too many interest rate cuts as these should not be justified if the economy is too hot. In our view there are two angles to take advantage of markets not entirely pricing in this view.
In terms of bonds, investors could essentially position more towards the start of the yield curve and keep some risk in terms of corporate debt.
In equities, the more prudent Fed cuts (slightly negative) could be balanced out with the fact that the economy remains strong (positive). In essence, those stocks which act as bond proxies such as those stable utility names with high dividend yields could be set to lose some of their shine. On the other hand, a more robust economy rather than a recession should be largely positive overall for equity markets globally, particularly those that are more sensitive to the economic cycle.
Structured products could also offer more precise payoffs to capture elements that may not be priced by the markets and to play a distinct market view. It is typically an area that requires distinct expertise and that could be particularly appealing for large investors.
Key risks to consider
Investors should consider that it should depend on the state of the economic activity over the next months, and how excess liquidity is faring. More than economic growth, whether we see a soft landing or if a recession materialises, the market reaction could be more significant on how the Fed’s communication is perceived and if it is enough to reassure investors.
This article is brought to you by the Advisory Solutions Team.
Contributors: Maxime Bonnet - Head of Advisory Solutions, Paul de La Baume - Investment Advisor