With the Fed's Rate Cut, Where Will Global Asset Classes Head?
In the early hours of September 19, Beijing time, the Federal Reserve made a pivotal decision to lower interest rates by 50 basis points, adjusting the federal funds rate target range to 4.75%-5%. This marked the first rate cut since the Fed initiated its tightening cycle in March 2022, signaling a significant shift in monetary policy amidst shifting economic conditions.
What prompted the Federal Reserve to reduce rates at this juncture? What can we anticipate regarding the pace and magnitude of future rate cuts? And how will these developments influence global asset dynamics? To provide a comprehensive context, we analyze the trends in major asset prices during the past six Federal Reserve rate cut cycles since 1995. This exploration aims to equip investors with insights for asset allocation strategies as we enter another phase of Fed easing.
The rationale behind the Federal Reserve's decision can be broadly categorized into two types: preventive and remedial cuts. Preventive cuts are implemented in response to early signs of economic slowdown to mitigate the risk of recession, while remedial cuts are necessary when the economy is already in recession or facing significant crises. The recent rate cut leans towards the preventive side, indicating that while the U.S. economy is showing signs of slowing growth, it is not yet on the brink of outright recession.
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Recent data reveals a cooling inflation scenario, with the Consumer Price Index (CPI) growing by just 2.5% year-on-year in August, marking the lowest growth rate since March 2021 and a decline for five consecutive months. Simultaneously, the labor market is beginning to cool; in August, non-farm payrolls increased by only 142,000, falling short of the expected 160,000. The unemployment rate also ticked up to 4.2%, up from a pandemic low of 3.4%. These signs collectively illustrate an economy transitioning to a more cautious state, yet without obvious indicators of a recession.
Despite the deceleration, the economy still exhibits resilience, particularly in the services sector, contributing to ongoing economic momentum. The Fed has revised its 2024 GDP growth forecast down from 2.1% to 2%, factoring in this cooling trend. The manufacturing sector is showing distinct signs of contraction, with the ISM Manufacturing PMI at 47.2%, remaining in the contraction zone for five consecutive months, while the services PMI rebounded to 51.5%, indicating moderate expansion.
Going forward, while we can expect continued resilience in the U.S. economy for the current year, pressures are likely to mount in 2025. The strong performance of the services sector, combined with the Fed's easing monetary policies, will likely support stability in economic activity. However, as labor market growth decelerates and consumers exhaust their accumulation of excess savings, risks of an economic downturn will inevitably increase.
Historically, in reviewing the previous six rate cut cycles by the Federal Reserve, we observe distinct patterns in terms of timing and extent. Preventive cuts typically occur at a slower pace with smaller reductions, while remedial cuts are characterized by more aggressive and extensive declines.
The recent 50 basis point rate cut slightly exceeded expectations, reflecting the Fed's enhanced confidence in meeting its inflation objectives, while also bolstering support for labor market goals. Traditionally, initial preventive rate cuts are initiated with a 25 basis point adjustment; hence, this more substantial reduction signals a stronger alignment with inflation management strategies. The Fed has downgraded its inflation expectations for 2024, projecting PCE inflation to be 2.3%, down from 2.6% previously forecasted in June. However, accounts of risks associated with workforce dynamics have also prompted the Fed to adjust its unemployment projections from 4% to 4.4% by year-end.
Looking ahead, we can anticipate additional rate cuts in November and December, expected to be 25 basis points each, culminating in a total of 100 basis points of cuts for 2024. As long as the U.S. economy does not present unmistakable evidence of slipping into a substantial recession, the Fed is unlikely to pursue a series of aggressive rate cuts.
Reflecting on past Federal Reserve rate cut cycles since 1995, we examine the corresponding trends in global asset prices, excluding the interruptions caused by the liquidity crisis during the 2020 pandemic. Overall, U.S. Treasury bonds and gold demonstrated notable resilience, while equities often performed poorly in tumultuous economic environments wherein remedial cuts occurred, placing pressure on the dollar.
A closer look reveals several critical observations:
Stock Markets: The trajectory of stock markets substantially correlates with economic fundamentals. During preventive cut cycles, wherein economic distress was absent, U.S. equities saw upward trends. Conversely, in remedial cut cycles, characterized by economic contractions, stock prices declined.
Treasury Bonds: Performance was robust, particularly for shorter-dated, lower-risk bonds, which benefitted significantly from rate cuts. Of the five recent cut cycles, U.S. Treasury yields rose in four instances. Other global bonds, including Chinese, Japanese, and European bonds, appeared to move independently from the Fed's policies.
The Dollar: Initially, the dollar saw depreciation pressures following the Fed's cuts—however, the longer-term value remained contingent on U.S. economic competitiveness, global risk sentiment, and trade conditions. This resulted in fluctuating exchange rates among currencies like the yen, yuan, and euro. Notably, the dollar experienced mixed trends three months after the initial cut.
Gold: Historically, gold has demonstrated strong performance, particularly during remedial cut phases, benefiting significantly from rate cuts.
For the stock market, the recent rate cut is perceived as a positive liquidity injection. Nonetheless, given the uncertainties surrounding the path of monetary policy and the elevated valuation levels of the U.S. stock market, caution is warranted against potential retracement risks.
Concerning bonds, U.S. Treasuries possess a solid level of certainty, and we can expect a slowing of downward yield trajectories, provided the current economic indicators do not signal significant recession signals. As such, projections suggest a moderation of yield declines.
In the foreign exchange market, the dollar appears under pressure, yet the resilient U.S. economy may offer some support. Concurrent Japanese rate hikes and fluctuating global risk sentiments could bolster the yen against this backdrop.
When considering gold, while short-term price corrections are possible, the longer-term outlook remains bullish. The market has demonstrated a tendency for "running ahead" of positive news, hinting at potential pullback risks in the immediate term. However, support factors like global de-dollarization and increased geopolitical tensions could sustain upward trajectories for gold prices.
The Federal Reserve's decision to lower rates opens up operational spaces for Chinese monetary policy. Externally, it alleviates constraints on further Chinese easing, such as reserve requirement ratio (RRR) and interest rate cuts. Internally, China's economic struggles largely stem from insufficient domestic demand, leading to supply-demand imbalances that necessitate a proactive macroeconomic stimulus to bolster consumption and investment.
The initiation of a rate-cut cycle by the Fed may help mitigate global economic deceleration risks, contributing to the resilience of China's exports. A stable American economy with eased monetary policies could provide external support, while the relative stability of the U.S. dollar diminishes the impact of the renminbi's appreciation on export competitiveness.
Additionally, the Fed's rate cut decision is likely to benefit China's stock and bond markets, providing necessary liquidity boosts while expanding the scope for domestic monetary easing. This could facilitate lower bond yields and stabilize the renminbi exchange rate against the dollar.
Risks to Consider: Unexpected declines in U.S. economic performance or escalated geopolitical conflicts may pose substantial risks going forward.
(This article represents the personal viewpoint of the author)