For the Fed, the time has come

• We expect the US Federal Reserve to cut rates by 25bp at its 18th September meeting, taking the target range for the Fed funds rate to 5.0-5.25%.
• However, a 50bp cut cannot be discounted given the recent softening in labour market activity and comments by some Fed policymakers to front-load rate cuts.
• Even if the Fed cuts rates by just 25bp at the September meeting, we still think that it will leave the door open for larger rate cuts at subsequent meetings, if evidence continues to mount of a further deterioratioon in the labour market.
• In recent weeks, interest rate markets have already begun to price the start of a Fed rate cutting cycle in September, with around 100bp of rate cuts now priced by-end 2024[1]. At this juncture, we broadly agree with this pricing.
• For bond investors, we think the macro and policy backdrop continues to favour a US yield curve steepening expression in portfolios.

The US economy is not currently flashing the warning lights of an impending recession. The unemployment rate, at 4.2%[2], remains low by historical standards and some of the rise in the unemployment rate has been driven by an increase in labour supply rather than weakening labour demand. The Fed’s dual mandate - maximum employment and stable prices - is tantalizingly within reach and our base case remains for a softening of the economy but not a hard landing.

However, recent US survey indicators point to ongoing weakness in manufacturing activity, while there are early signs of a slowdown in the all-important service-side of the economy. In addition, there have also been some tentative signs that consumer demand is coming off the boil, with spending amongst low-income households in particular starting to come under pressure against the backdrop of a slower pace of hiring and softening average earnings growth.

Therefore, we believe it is time for US Federal Reserve to act and expect a rate cut of 25bp at its 18th September meeting, taking the target range for the Fed funds rate to 5.0-5.25%.  

With the Fed’s preferred core PCE inflation measure also inching towards the 2% target (currently at 2.6% y/y[3]), recent comments from Fed policymakers would suggest a willingness to act forcefully if labour demand weakens further.

The global economic growth backdrop also underpins a desire within the Fed and other G10 central bankers to loosen their restrictive monetary policy stance. Chinese growth continues to disappoint, while growth in the Euro area has also been underwhelming, especially in Germany. As a consequence, commodity and energy prices are coming under downward pressure and helping to anchor inflation expectations globally.

The Fed, like other central bankers, are now focused on economic growth rather than inflation risks and becoming increasingly worried about being behind the curve on policy – cutting rates too late to avert a recession or sharper growth slowdown.

Therefore, in our view, the risks of larger rate cuts at subsequent meetings this year cannot be discounted, especially if labour market activity deteriorates faster than currently expected and inflation continues to head towards target.

For bond investors, we think that the path of least resistance over the coming months is for lower sovereign bond yields and owning bonds at this stage of the economic cycle is an attractive proposition. We favour a long interest rate duration stance in several sovereign bond markets and have a preference to be positioned for steeper yield curves, especially in the US and Euro area.

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[1] Bloomberg 10 September 2024

[2] Bureau of Labor Statistics, 6 September 2024

[3] Bureau of Economic Analysis, 30 August 2024