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Weekly Market Analysis - Fed Shifts to Protect Expansion – Looking Beyond the Obvious (Part 2)
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Powell at Jackson Hole: Policy Will Pivot to Protect Growth
At his Jackson Hole speech last week, US Fed Chair Jerome Powell made it clear that policy is pivoting to protect the US expansion. “The time has come for policy to adjust … We do not seek or welcome further cooling in labor market conditions…(with) appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2 percent inflation while maintaining a strong labor market.”
Markets Reacted Positively
The Fed Chair’s comments may have once again caught “market timers” off guard following a fast recovery from market declines early this month. With Powell noting the Fed has “ample room to respond to risks,” markets reacted with greater confidence in the growth outlook. Equities and credit markets rallied, bond yields and the US dollar fell.
Citi View: Rates Headed to 3.5%
We believe the Fed will deliver a series of 25 basis point rate cuts in succession through 1H 2025, ultimately taking policy rates to about 3.5%. We would expect deeper cuts if the economy falters. As we’ve often noted, long-term US Treasury yields should anchor near 4% on average. Global shocks would temporarily cause US yields to drop significantly further. Different scenarios for global growth, US labor force participation, and productivity could alter the trend in average US yields, both higher and lower .
Summary
Last week at the annual Jackson Hole Economic Symposium, Fed Chair Powell delivered the words many investors long expected. He also said much more.
“We do not seek or welcome further cooling in labor market conditions…The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
The largest impact from Powell’s speech was on world equity markets with broad US shares initially rising more than 1%, the US dollar and bond yields moderating. Both sovereign bond and corporate yields fell. Traditionally, emerging markets (EM) in Asia react positively to rate cuts by the Fed, especially if not associated with a US recession (see chart). Stable global demand growth and more ample USD liquidity tends to boost growth in the region and attract capital inflows from both bond and equity investors.
Portfolio considerations
Traditionally, emerging markets (EM) in Asia react positively to rate cuts by the Fed, especially if not associated with a US recession. However, China and US tariff policy complicate the story. This favors markets with strong domestic growth momentum like India and markets with secular industry growth like Taiwan and Korea (along with Japan). Hong Kong is a special case in Asia where US policy easing will help unwind a historically high rate premium vs China.
Source: Bloomberg as of August 20, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Powell at Jackson Hole: Policy Will Pivot to Protect Growth
In a historically clear speech, the Fed Chair noted that the healing of pandemic distortions and the Fed’s tightening worked together to swiftly reduce inflation in the past two years. Rather than require a sharp rise in unemployment to push inflation lower as some have called for, he noted the economy’s ability to adapt to shocks: “As so often happens in times of crisis, Americans adapted and innovated.” The same could be said for much of the world to varying degrees.
Hearing Powell’s strong words, one could expect more of the same trifling debate: “will it be a 25 or 50 basis point rate cut” at the September 18 FOMC meeting? Powell’s “dovish” speech might mean a larger cut. Yet counter-intuitively, Powell’s strong commitment to protect the expansion resulted in incremental strength for risk assets – driven by greater confidence in the growth outlook – than declines in short-term yields. After the Chair’s speech, very short-term Treasury bill yields rose and the futures contracts placed the odds of a 50 basis point rate cut as only slightly higher. Markets priced greater likelihood of an extended period of 25 basis point cuts through 2025.
Markets React Positively
The largest impact from Powell’s speech Friday was on world equity markets with broad US shares initially rising more than 1%, the US dollar and bond yields moderating. Both sovereign bond and corporate yields fell. Traditionally, Emerging Markets (EM) in Asia react positively to rate cuts by the Fed, especially if not associated with a US recession. Stable global demand growth and more ample USD liquidity tends to boost growth in the region and attract capital inflows from both bond and equity investors.
However, this cycle, two overhangs may complicate the story and diminish the tailwind effect of Fed easing, namely China’s economic weakness and potential escalation of trade conflicts. This backdrop would favor markets with strong domestic growth momentum like India and markets with secular demand growth like Taiwan and Korea (along with Japan). For markets that depend more on traditional industrial demand like Southeast Asia, the situation may be more neutral from a growth perspective.
With significant uncertainty from China and trade, equity investors are likely to prefer markets with more proven earnings growth. In 2024 so far, Asian equities performance had been largely consistent with forward EPS revisions. Markets with significant semiconductor component like Taiwan and Japan got the largest upward revisions and top performance. Korea’s performance was weaker as its semiconductor industry was not as competitive, while its heavy industrial sector suffered from poor demand. Similarly, India remains the market seeing the highest economic growth, with strong upward revisions. These markets may remain investor favorites if US rate cuts bring more interest in Asia.
Citi View: Rates Headed to 3.5%
We believe the Fed will deliver a series of 25 basis point rate cuts in succession through 1H 2025, ultimately taking policy rates to about 3.5%. We would expect deeper cuts if the economy falters. As we’ve often noted, long-term US Treasury yields should anchor near 4% on average.
Latin America is another region where external conditions should improve with an easing Fed. Yet Latam markets have underperformed year-to-date, hampered by sharp exchange rate appreciation in 2023. For Brazil, we find the macro framework to be more sustainable than markets are pricing in at present. In Mexico’s case, US trade risks and domestic politics suggest a somewhat more cautious approach in the near term. However, valuation opportunities are becoming more attractive.
