We kick off September with one eye firmly fixed on the upcoming ECB and Federal Reserve meetings this month, held on the 12th and 18th respectively. With inflation slowing down and weaker prospects for economic growth, with a focus on the US labour market in particular, investors are supporting the idea of both lowering their benchmark rates. Just in case there were any doubts, Jerome Powell, Chair of the Federal Reserve, already conveyed the message in August’s traditional central bank meeting in Jackson Hole that the time had come for monetary policy to be tweaked. It will join the Bank of England, the ECB, the Swiss National Bank, the Bank of Canada and the Reserve Bank of New Zealand, which have already begun lowering rates.
With three meetings scheduled before the turn of the year, the market expects the Federal Reserve to cut rates by 1% and the ECB to do so by 0.6%. Therefore, we are expecting a rapid adjustment, and we will have to wait and see if it will be implemented by the major Central Banks. The objective is to avoid any ‘policy errors’, and to do so, they will have to focus on the forthcoming economic data and place less importance on future estimates.
Analysis of their subsequent message on monetary policy decisions will be crucial. Until now, inflation has been the determining variable (if not the only variable) for Central Banks, and seeing if they now add economic weakness as a variable to be taken into consideration in their decisions will be a significant step. This will have a direct impact on the evolution of risk assets, as lowering rates because inflation is being controlled, consistent with what they have maintained during this cycle of rate hikes, is not the same as lowering rates due to a weak economy. It is also key to calculating the neutral rate, which neither stimulates nor restricts economic activity, and which serves as a basis for attempting to determine long-term interest rate expectations.
This expected easing of monetary policy is a catalyst for fixed income assets, which still have a yield that is well above the average seen over the last decade.
Another positive development for this asset class is that it is regaining its role as a diversifier and safe haven asset. The traditional situation in which fixed income offered hedging and compensated for losses when equities fell had not worked in recent years. It was particularly painful in 2022 as rising inflation forced the Central Banks to implement a rapid and aggressive rate hike. Now, however, the correlation between these assets is negative again and bonds are once more offering protection in times of heightened uncertainty. We saw a recent example in early August when, with the closure of carry trades (a strategy that capitalises on differences between the interest rates of two currencies) due to the appreciation of the YEN, together with doubts about the US macroeconomic situation, poor results in the technology sector (mainly due to the failure to confirm the rapid return of AI) and the increase in geopolitical risk in the Middle East caused the stock markets to plummet, which was compensated by bonds. As a result, between 31st July and 5th August this year the MSCI World equity index fell by 6.4% while the Bloomberg Global-Aggregate Total Return fixed income index rose by 2.13%.
Bonds are performing very well in this climate while offering room for further appreciation. With falling rates and the recovery of their use as diversification tools, cash flows should continue to flood in from asset selectors and investors looking for a more defensive investment given the geopolitical and economic uncertainties and the upcoming elections in several countries.
Rankia Pro 10.09.2024