“Higher for longer – no longer, the easing cycle begins”

Marco

Last week, the Fed made a decisive move by cutting interest rates by 50bps, signaling the start of its policy easing normalisation. This decision was largely anticipated by markets to support economic resilience, and today we will examine the implications of this rate cut cycle, how it differs from previous ones, and strategies to navigate it going forward.

Unlike previous rate cut cycles—such as those during the GFC or the COVID-19 pandemic—the US economy today is better positioned for what many expect to be a “soft landing.” We are currently in a mid-to-late-stage economic cycle, where risks of an imminent recession remain muted. Despite global uncertainties, consensus forecasts for US GDP growth have been stable, reflecting optimism in the market. The FOMC also expressed confidence in the strength of the US economy, indicating that while some challenges remain, the outlook for growth and employment is stable.

The Fed’s decision, however, to implement a more aggressive 50bps rate cut, as opposed to 25bps, highlights concerns surrounding downside risks in the labor market. Although the overall economic outlook remains positive, there are signs of softening in employment. Consensus forecasts suggest that US non-farm payroll growth will remain flat over the coming quarters. Policymakers have reiterated that they are not behind the curve but acknowledged that had they seen the July employment data sooner, rate cuts might have been initiated earlier. This proactive approach signals that while the Fed acknowledges risks, it is striving to balance those against broader economic health.

Looking ahead, we anticipate this rate cut cycle will be gradual, with another 200bps of cuts expected in 25bps intervals extending through the end of 2026. The terminal rate is forecasted to stabilise at around 3%, provided the economy continues its current trajectory. However, any signs of material weakening in economic indicators could prompt more aggressive cuts.The Fed will remain highly data-dependent in its decisions, with inflation and labor market trends playing key roles in shaping future policy moves.

One useful tool in understanding the Fed’s decisions is the Taylor Rule, a model that estimates the appropriate level for the Fed funds rate based on inflation and labor data. In August, the Taylor Rule estimated the appropriate rate to be 5%. With the recent cut, the Fed has lowered the target rate to 5%.However, if inflation were to decline to 2% and the natural unemployment rate hovered around 4.4%, the estimated rate would be closer to 4.05%, still above the market’s forecasted terminal rate of 3%. This suggests a tilt towards a more pessimistic scenario, where downside risks to growth,or a hard landing, could lead to further easing.

In conclusion, navigating this rate cut cycle will require careful monitoring of economic data and Fed actions. The pace and magnitude of rate cuts will have an impact on the pricing of risk-on assets. Additionally, as we approach the USelections in November, political uncertainty could exacerbate market volatility. A balanced approach, with an eye on cyclical sectors and risk management, will be crucial as we move into Q4 2024.

Bonds

US yields drifted higher post the September FOMC. Markets are unlikely to price a faster pace of cuts or a lower terminal rate until the September employment data in about 2 weeks’ time. A decisive factor will be the path of the unemployment rate, where 12 of 19 FOMC participants see the risks to even their new higher forecasts as tilted to the upside. This suggests a risk of more dovish Fed action, such as cutting another 50 bp in November, in the event of further labour market cooling and/or downward revisions to historical data. Expect that any rise in yields over the next several weeks will likely be limited, particularly at the front end. We are inclined to increase duration of bond portfolios.

Asia credit spreads have partially, but not fully, recouped the losses from early August. Spreads on the Bloomberg Asia USD Investment Grade index widened by 14 bp to 98 bp between 1st August and 5th August and spreads on the Bloomberg Asia USD High Yield index widened by 61 bp to 551 bp over the same period. Since then, much of the spread widening in Asia IG was recouped, with the Bloomberg Asia USD IG spread currently at 89 bp compared with 84 bp on 1 Aug. However, spreads on Asia HY widened further, with the Bloomberg Asia USD HY spread currently at 566 bp compared with 490 bp on 1st August. The spread widening in Asia HY was concentrated amongst China names. Furthermore, over half of the issuers are China property developers. The weakness can be attributed to the strong 11.6% return year to date in China HY and lingering concerns on the China real estate sector. With no clear signs that the China property sector is stabilizing and elevated volatility across China HY, we are inclined to maintain up in quality positioning within China property credit.

Asia USD High Yield Index OAS Remains Wider Since August

Source: Bloomberg Finance L.P.

Equities

The Australian Prudential Regulation Authority (APRA) has proposed phasing out Additional Tier 1 (AT1) such that regulatory capital requirements will be met with common equity and Tier 2. While Australian banks are fundamentally well-capitalized, the proposal is negative for Australian bank Tier 2, given possible rating downgrades and spreads widening to reflect Tier 2 becoming the only class above common equity to absorb losses, and that Australian banks would likely increase Tier 2 issuance as and when the rules are finalized. Existing AT1 instruments would be eligible to be included as Tier 2, until their first scheduled call date. All existing AT1s would reach their first call date by 2032 at the latest and APRA stated to not expect approval on regulatory calls at an earlier date than the first call date. Going forward, anticipated increase in Tier 2 supply and cessation of AT1 issuance should drive relative outperformance of AT1. We are inclined to switch positioning from Australian bank Tier 2 to AT1.