Softly, softly
Long awaited and perpetually postponed, this time they look to be imminent – key rate cuts by the US Federal Reserve (Fed) should finally kick off at the FOMC meeting on 18 September. The market is banking on a cut of at least 25 basis points, which will reduce the upper end of the band to 5.25% from 5.50% currently. There is even serious talk of a 50 basis points cut. Furthermore, the market believes that this initial move will be followed by a series of two or three additional cuts of 25 basis points by the end of 2024, with another four by summer 2025 – 200 basis points in total within a year.
But there must be a softly-softly approach to these cuts! If this is not the case and we see a quick-fire round of significant cuts, this will be down to one of two factors, both of which are problematic. The first would be a very rapid resurgence of inflation, which is hard to imagine from today’s perspective and would have to originate from instability in the economic system, e.g. a contraction in demand, a strong fall in corporate margins, a brutal appreciation of the dollar, or fierce competition from Chinese products. The second, would be a sharp economic slowdown. In all events, a series of quick-fire rate cuts would signal the end of the euphoria in which the market has been basking for over a year, rejoicing in a soft landing that has been achieved with impeccable precision thus far.
For the softly-softly approach to prevail, there must be no further intensification in a number of worrying trends. The first of these is the rise in US unemployment from 3.7% in January to 4.3% in August – even if the surprising July figures could in part be explained by deteriorating weather conditions. Another worrying trend is the parallel fall in the rate of new jobs creation to a 3-month moving average of 170,000 per month in July, the weakest level since the end of 2019 if we exclude the period of the Covid crisis. None of this is particularly worrying, but such developments automatically move the US economy away from a soft landing and towards a hard landing scenario. Holding the economy in soft landing territory is particularly difficult with real interest rates (i.e. inflation adjusted) as high as they are today. With 3-month rolling inflation at 3%[1], short-term real rates are close to 2.5%, and with the nominal 10-year yield at close to 4% last month, long-term real rates are still over 1%. In other words, the Fed is still throttling the economy, even though employment and inflation momentum are weakening. The risk of excessive tightening is clear.
Despite this, the market remains extremely calm, barely troubled by a short-lived bout of volatility at the beginning of August, which has subsequently disappeared. It is thus counting on the Fed indefinitely meeting the difficult challenge of applying only the strictly necessary degree of braking. Can such a feat be repeated forever? Certain legendary Olympic champions, who were challenged for the umpteenth time this summer, may encourage us to believe this. Can Jerome Powell join their ranks, with the medal for the softest easing possible?
Final version of 23 August 2024 – Alexis Bienvenu, Fund Manager, LFDE