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Interest rate cuts at the door

Interest rate cuts at the door
(c) Jose Luis Magana / AP / picturedesk.com
Created by | Published on | Topics: Bonds , Markets
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The US Federal Reserve is expected to start a rate-cutting cycle on Wednesday. At least, this is indicated by the numerous statements made by Fed members. However, this cycle has already seen the start of rate cuts being priced in several times, only to be followed by a disappointing inflation surprise shortly thereafter. This time, too, core inflation (the total consumer price index excluding food and energy for the month of August) rose by 0.3% month-on-month. The estimate was 0.2%. However, the trend of the numerous indicators for underlying inflation is clearly pointing downwards. On an annualized basis, core inflation rose by only 2.5% year-on-year. Excluding the estimated component “owner’s equivalent rent”, inflation would be significantly lower. In July, the European Central Bank’s consumer price inflation (HICP) for the US was only 1.7%.

Why key interest rates are falling now

The key points of the upcoming interest rate cuts have already been outlined by some Fed members:

  • The risks have shifted away from inflation and towards employment. Therefore, monetary policy must be adjusted accordingly
  • It is time to lower the target range for the federal funds rate at the next meeting.
  • It is likely that a series of cuts will be appropriate.
  • A further weakening of the labor market is not desirable.
  • Determining the pace of interest rate cuts and ultimately the overall reduction in the key interest rate are decisions that lie in the future.

Key Interest Rates Developed Markets


By the end of 2025, US key interest rates could fall to 3%

In April, market prices still only reflected a moderate downward adjustment of the key interest rate (minus 1 percentage point to 4.5% by the end of 2025). In the meantime, however, we can speak of an interest rate cut cycle. It is not clear whether the key interest rate will be cut by 0.25 or 0.5 percentage points next Wednesday. In any case, the market prices indicate an equal probability for both events. One argument in favor of a 0.5 percentage point cut is that the central bank no longer wants to appear restrictive. This means a rapid reduction to a neutral level. At the end of 2025, the key interest rate could be 3% (one percent real neutral interest rate plus two percent inflation).

ECB delivers “hawkish” interest rate cut

Last Thursday, the European Central Bank (ECB) cut its key interest rate for the second time this year. The key interest rate (deposit facility) was cut from 3.75% to 3.5%. A clear difference to the US Federal Reserve (Fed) is noticeable in the guidance of market expectations (forward guidance). In order for inflation to return to the medium-term inflation target of 2 percent in the near term, sufficiently restrictive key interest rates are necessary. By contrast, the Fed’s signals imply a reduction to a neutral level. In doing so, it will continue to pursue a data-dependent approach. The ECB thus continues to have little confidence in its forecasts. By contrast, the Fed’s signals point to a series of cuts.

ECB forecasts with weaknesses

In any case, the projections for inflation assume a decline in core inflation (total number excluding food and energy) from 2.9% this year to 2.3% in 2025 and 2.0% in 2026. The weakness of this expectation is the persistently high inflation in the service sector (August: 4.2% year-on-year). Economic growth is expected to increase from 0.8% in 2024 to 1.3% in 2025 and 1.5% in 2026. The driving factor behind this should be the rising real incomes of households, which should lead to higher private consumption. This expectation has already been in place for this year, but it has been disappointed.

Slow ECB rate cuts to 2% in 2025

As long as the eurozone continues to show slight growth, the ECB is likely to lower key interest rates only slowly. This means a further interest rate cut in December this year. A key interest rate of 2% could be reached by the end of 2025. This value corresponds to a rough estimate for a neutral level (zero percent real neutral interest rate plus two percent inflation).

Loss of competitiveness in the EU

However, cuts in the key interest rate can only help to a limited extent. One important structural deficit in the European Union is stagnating productivity. Mario Draghi’s report on the competitiveness of Europe (“The future of European Competitiveness”), published by the European Commission on September 9, can be interpreted as a wake-up call. “The EU has reached a point where, without action, it will endanger either its prosperity, the environment or its freedom.” Among other things, Mario Draghi proposes massive investments in innovation as well as the expansion and further integration of the European capital market. As long as the measures are not implemented, growth figures for the gross domestic product of less than one percent will no longer be an exception.

Structural problems in China

China is facing several problems: weak domestic demand, the downward adjustment in the real estate sector and overcapacity. The recently published economic data for August point to continued low growth in the third quarter and persistently negative inflation. Total credit growth continued to fall (total social financing in August: 8.1% year-on-year, down from 8.2% in July). The increase in the net issuance volume of government bonds made a significant contribution to this. The growth of bank loans weakened further from 8.7% year-on-year to 8.5%. The credit impulse (change in loan growth relative to nominal economic growth) has now been negative since February. Industrial production also weakened further (August: 4.5% after 5.1%).

Among the various sub-categories, export-oriented and high-tech companies posted strong growth. Retail sales growth remained below industrial production growth at 2.1% year-on-year (July: 2.7%). This continues to keep prices under pressure. Investment activity weakened further (January through August: 3.4% year-on-year). Real estate investment continued to contract sharply (10.2%). The estimate for real GDP growth this year is 4.6%. The risks are to the downside. China is no longer the global growth engine.

The structural problems in China and the European Union are increasing the importance of the US for the financial markets. Economic growth of 2.5% is expected in the US this year, which in the baseline scenario weakens to 1.7% next year. At the same time, inflation is falling towards the central bank target, causing the Fed to rapidly lower the key rates to a neutral level.

Conclusion

This environment is generally favorable for risky asset classes such as equities. However, downside risks (recession risks) have increased in the US in recent months due to the weakening labor market. For this reason, we have underweighted equities and overweighted bonds.

For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management

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Prognoses are no reliable indicator for future performance.

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