After four years of interest rate hikes to combat the inflation caused by lax monetary policy, it seems a shift is underway. If we look back in time, which is always useful given our human tendency to forget, it’s important to remember that we have faced a series of crises in recent years (the most notable and significant being the Great Financial Crisis of 2008 and the COVID crisis in 2020, although we have endured a few more along the way). The solution adopted in response to this context was to keep interest rates at all-time lows (negative in many cases) over a very long period. The result for the economy, apart from avoiding painful recessions, was the generation of inflationary pressures due to excess money in circulation. This came to a head in 2022 with inflation exceeding 10% in many developed countries.
Central banks reacted swiftly and aggressively, starting to raise official rates between 2022 and 2023 in an attempt to lower the price level. After some initial uncertainty, it seems that by 2024 the battle is being considered won, and monetary authorities have begun to change their rhetoric and decisions.
This September—after months of hesitation to avoid rushing the change—the recent decision by the Federal Reserve (Fed) to lower rates by half a point seems to confirm a definitive shift in the direction of central banks. While the size of the cut came as a surprise, the decision was not altogether unexpected as other central banks had already begun implementing rate reductions. For instance, the ECB has made the same reduction, but in two meetings: in June and September.
If we are to take Fed Chairman Jerome Powell at his word, this is just the beginning of the interest rate reduction phase. Based on his subsequent statements, if the US economy performs as expected before the end of the year, we may anticipate a further cut of 50 basis points and 1% by 2025. It is well understood that if the Fed follows this strategy, the other central banks will also jump on board sooner or later.
So what would this decision mean? The most obvious and noticeable implication is the reduction in mortgage costs (and other forms of financing). However, it is not so clear how the financial markets would respond. It will be crucial to determine whether the cuts are primarily a result of inflation control, as is being suggested, or if they are more driven by fears of an impending economic recession.
If we subscribe to the current ‘soft landing’ thesis without inflationary pressures, we can expect a normalisation of the yield curve (meaning that longer-term debt will offer higher returns), benefiting investors holding long-term fixed-income assets in their portfolios. For equity markets, this scenario is the most favourable, as it ensures a certain pricing power (price growth) and sustained demand. This will lead to positive corporate profits and, consequently, the potential for continued rises in international stock markets.
Conversely, if inflation proves resistant to dropping into the comfortable 2% range and economic growth slows more than anticipated in the coming months, the markets may respond quite differently. In that case, we would be facing stagflation, leaving central banks caught between a rock and a hard place. They could not cut rates at the desired pace to avoid increasing inflationary pressures, nor could they raise them without causing further strain on the economy. Therefore, international stock markets would likely react with profit-taking and widespread corrections, while fixed income assets could serve as a safe haven for investors.
In summary, the reduction in interest rates is welcome (at least for me personally as a mortgage holder), but we remain cautious as to whether this will guarantee ongoing gains in international stock markets. We will need to keep a close eye on upcoming macroeconomic data (particularly GDP, inflation and the labour market) to anticipate financial market trends. In the meantime, being cautious and diversifying our investments will be essential to avoid too much stress and sleepless nights.
Diari d’Andorra, 26.09.24