Since the US Federal Reserve’s pivot late last year, the market has been anticipating rate cuts – the question being when, not if, the Fed will make its first move. Until recently, four cuts were priced in for this year.
That assumption, however, is being increasingly challenged – to the consternation of investors who have been eagerly awaiting a U-turn.
Darrell Spence, economist at Capital Group, said that if the Fed doesn’t cut rates before year’s end, “this may sound akin to cancelling Christmas” for some investors.
However, given higher-than-expected inflation, “there is a strong chance we will get no rate cuts at all this year”.
He gave three main reasons for why he expects the Fed to demur: US economic strength, inflation and the resilience of financial markets.
First reason: The US economy can handle it
This week, the Fed announced it is keeping rates within a range of 5.25% to 5.5%, its highest level in more than 20 years.
And yet last week, the International Monetary Fund raised its forecast for US economic growth to 2.7% on an annualised basis, compared to 0.8% for Europe and 0.9% for Japan.
“The US economy appears to have adjusted quite well to a higher interest rate environment. Its resilience in the face of much higher interest rates has been one of the biggest surprises of the past two years,” said Spence.
“This type of solid growth is not normally associated with rate cuts. Given this resilience, there is reason to worry that the US economy could overheat if the Fed lowers rates prematurely, which could reignite inflationary pressures.”
Second reason: Inflation is stubbornly sticking around
US prices have fallen from the highs of June 2022, but the Consumer Price Index for All Urban Consumers still rose 3.5% over the last 12 months. Going that final mile to reach the central bank’s 2% target could be the toughest part of the journey, according to Spence.
“One might think inflation in the range of 2.5% to 3% is close enough, but the Fed has repeatedly stressed the importance of that 2% goal. We should assume that 40 or 50 basis points above target is too high,” he said.
“If the Fed does not cut this year, it will likely be because inflation is not falling as quickly as anticipated by central bank officials. That is a likely scenario.”
Third reason: Financial markets are fine with the status quo
US and international stock markets hit a series of record highs in the first quarter of 2024. According to the Capital Group economist, stocks have been able to overcome the fear that higher interest rates would kill the bull market.
“Markets can react violently at the beginning of a rate-hiking campaign, as we saw in 2022, but once we reach a new level of stability, they have often been able to resume their long-term growth trajectory – influenced more by corporate earnings and economic growth than monetary policy,” Spence said.
What should investors make of all this?
Spence sought to reassure investors that low rates are not necessary for markets to thrive.
“If the Fed decides to stand firm, it is not necessarily a bad outcome,” he pointed out.
“Fed officials want to cut rates, but as investors, we need to question that assumption and consider the possibility that, in light of recent healthy growth, maybe Fed policy is not restrictive.
“Maybe that’s why we haven’t had a recession. And maybe that’s why we won’t get a rate cut in 2024,” said the economist.
“Rather than being a negative, however, the absence of a rate cut this year could simply reflect the fact that the US economy is doing quite well.”
History suggests this could be a good time to remain invested in both equities and credit-oriented fixed income, provided that investors are willing to take a long-term view, he added.