(a short read)
Is it just me, but do the markets always seem to be a host to a bunch of irrational swing traders who gamble life savings on the bets left right and centre? This year, the hot gamble has been the prospect of rate cuts. Where’s it going?
I took a look at what people were pricing in this year: 100bps of cuts by the Fed, and another 75bps in the EuroZone. Damn, that took a quick turn since more pessimistic sentiments just a couple of weeks ago wasn’t it? I swear just a little earlier lads were floating around the prospects of having no rate cuts this year amidst strong economic data and a stickier-than-expected inflation readings. What changed?
August historically has been a horrible month for equities, crypto… whatever risk assets. And this year was no exception. We saw:
- Strong appreciation in the Yen and the unravelling of the Global Carry Trade
- Weak (and revised!!) jobs data that sent bears into panic attacks
- Favourable inflation numbers (no reason for Volcker 2.0 to keep rates up anymore!)
- Central Bank openness to cuts at Jackson-Hole
All of which further fuelled bets that rate cuts were coming, and fast. I think that there are some key things that i will address here first that in my opinion is wrong.
Markets are pricing in huge rate cuts primarily due to:
- Strong progress in the disinflation narrative
- Worries about the macroeconomic strength due to rising delinquency rates, slowdowns in large purchases as well as the weak jobs data
- Markets seem to think Central Banks are pivoting away from the hard 2% inflation target
- Hence they are seeing this as a recessionary cut
- Markets also are seeing this as the beginning of the rate cutting cycle
These are mostly correct points, except the last two. I will touch on the last point later on. But recently I’ve been seeing bears on twitter, telegram, whatever sites talking about how a recession is coming by referencing how previous rate cuts have played out. I dare tell you this time is not the same; historically Central Banks have taken drastic monetary easing during times where there has been a severe contraction in activity, or drastic collapse in financial conditions —all of which are not applicable today. The rate cuts of 2000, 2007, 2020 are NOT the same as the normalisation cuts we are doing today to return back to normalcy in financial conditions and prevent the scenario where we have to do recessionary cuts. So no, don’t look at previous rate cuts and freak out please, consider the contextual difference.
Markets are wrong again?
Since the beginning of the year, I’ve always thought that the markets were always way too optimistic about the rate cutting cycle (they just wanted quick cash!). Here’s why I think they are getting some things wrong again:
Hol-Up on the Rate Cutting Cycle
Once again we see the markets getting over their heads about the rate cuts. Assuming we do not go straight into an issue on fiscal dominance (read this to find out more), strucutural drivers of inflation will always be here to stay and the combination of these macro drivers is causing the neutral real interest rates to stay elevated above historic levels. These include the low carbon transition, ageing demographics, AI and data centre energy requirements and the restructuring of global supply chains. Additionally, BlackRock aptly notes in one of their pieces that we likely do not revert back to a period of ultra loose monetary policy. After all, that decade’s super low rates were meant for hammered financial institutions and banks to leverage up and rebuild their balance sheets. That’s not what we need today.
And don’t you think these rate cut bets by retail and institutional investors are too short term greed driven? They have been wrong throughout the year and are not immune to mistakes –look how investors rushed to deleverage during the carry trade unwinding and now are rushing back in again. What??
The Fed is going to be SUUUUPER careful
Say goodbye to optimistic 100bps cut expectations guys, that’s likely not happening. We just saw the rapid unwinding of the carry trade and the huge macroeconomic implications it brought, why would the Fed ever think of going further down that hole in a mad rush? Look at this:
- The data isn’t as bad as we think it is — we’ve just had one month of bad labour data amidst a year of strength and resilience. The economy won’t blow up just because we didn’t rush to the gates and let credit flood the economy again. And labour market data is hugely difficult to unravel in my opinion, considering in this election year where border control is such a topic of contention, immigrants likely want to flood on fear of a Trump presidency. So the higher unemployment rate might be driven by them
- Neither the Fed nor the BoJ want to further destabilise the global capital markets with further threats to rate differentials, at least before they come out with a comprehensive and structured way to slowly ease and tighten their economies. The BoJ also has trillions in foreign assets and domestic pension funds are hugely dependent on foreign earnings. If the Yen were to appreciate too much and fuel another wave of reverse carry trades, global markets including the Japanese is likely to be hit again even harder. Neither side definitely doesn’t want this, and I see them closely communicating regarding swap lines and measured rate cuts/hikes to ensure that the world doesn’t crumble
ECB likely cuts more aggressively than the US
It doesn’t make sense to me that the EU would be the less aggressive one. They are struggling with structural issues far worse than what the US is going through, especially with respect to domestic output and demand. Relief is going to be largely beneficial for stretched-out households and consumers.
It’s also nice to consider that the previous rate cut didn’t significantly stimulate key economic metrics. The ECB likely has to rely on more to churn their machines and get industries back on track again. But it does seem like the EU is on a downward spiral as they lose key comparative advantages in industries to China. Internal politics have also never been more turbulent, with the riots and unrest in the UK, the whole fiasco about elections and Macron in France. But the ECB just like many other global central banks, follow the Fed closely for guidance (or ‘permission’ to cut rates!).
Pinch of Salt
This are just some of the thoughts I have regarding the entire uncertainty so far. AGAIN, I have to reiterate this isn’t investment advice, please don’t trade on these recommendations! Its easy to feel confused in the fog of this weird economic era we are in. So just sit back, sip some tea, and stay invested 🙂
Palm Holdings 
Leave a comment