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The Federal Reserve looks set to cut interest rates later this year, buoyed by inflation easing further after first-quarter surprises, as this week’s CPI data should reaffirm. Yet looking ahead, the Fed and its developed market (DM) peers will have to keep rates higher for longer as inflation settles above their 2% targets, we think. Some emerging market (EM) central banks are facing this fact, pausing their rate cuts with rates well above pre-pandemic norms. We lean into quality in fixed income.
Falling inflation has allowed DM central banks, like the European Central Bank, to start cutting rates recently. The Fed and Bank of England are likely to cut later this year. We think the odds of a Fed rate cut in September are marginally higher after the June U.S. job data. An average of about 180,000 monthly jobs have been added in the past three months – a level we think the economy can sustain for now without risking wage pressures given the surge in immigration. Yet we don’t think that pace of immigration can persist. Plus, the pace of wage growth is still consistent with inflation above 2% in the medium term. The Fed has upped its long-term policy rate projections as it and its DM peers accept they’ll have to keep rates higher for longer due to supply constraints. EM central banks have been ahead in both hiking and confronting that reality after the pandemic. See the chart below.
Many EM central banks started cutting rates earlier this year – some as early as 2023 – as growth has moderated and with support from cooling inflation. Now those EM central banks are nearing the end of their easing cycles as they confront varied constraints on how much they can cut rates. EM central banks can only go so far in cutting rates, especially when DM central banks – notably the Fed – are holding interest rates steady or slow to cut. Such a policy divergence can hurt the local currency against the U.S. dollar, and some economies are more sensitive to the resulting inflation from a weaker currency.
Some EM central banks have highlighted other concerns as the driving force behind plans to pause rate cuts.
Brazil’s central bank held rates at 13.75% for a year after launching hikes in 2021 from a low of 2%. It has since cut rates to 10.5% as inflation has fallen to target. But it halted rate cuts in June, citing questions over the impact of loose government fiscal policy on inflation.
Poland’s central bank has frozen rates at 5.75% since October after two rate cuts. Why? Uncertainty over how the government ending measures to shield households from high energy costs will affect inflation, prompting the Polish central bank to boost its inflation forecast for next year.
We see both EMs and DMs facing structural sources of higher inflation after the pandemic, including elevated public debt and geopolitical tensions leading to a rewiring of supply chains.
Higher-for-longer rates does not have to be bad news for risk assets, as we’ve seen this year. Top tech firms beating earnings expectations due to the artificial intelligence theme helped push stocks to record highs even as bond yields have risen on reduced Fed rate cut expectations.
We stay overweight U.S. stocks and prefer quality income in short-term government bonds and credit. We went overweight EM hard currency debt, typically issued in dollars, in August 2023 just as EM central bank rate cuts were gearing up. We expected local currencies to fall against the dollar, hurting EM local currency debt. As that played out, EM hard currency debt has performed well. But we’re reassessing our view as EM central banks pause rate cuts.
We think DM central banks will keep policy rates higher for longer than before the pandemic – just like EM central banks are doing now. We stay overweight EM hard currency debt yet stand ready to pivot as central banks shift policy.
Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.
Wei Li is Global Chief Investment Strategist, Blackrock Investment Institute at BlackRock Inc.
Axel Christensen Chief Investment Strategist for Latin America — BlackRock Investment Institute, and Nicholas Fawcett Macro Research – BlackRock Investment Institute, contributed to this article.
Excerpted from the July 8 BlackRock Weekly Commentary.
Disclaimer
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© 2024 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared July 8, 2024, on the BlackRock website. Used with permission.
Image: iStock.com/JanPietruszka
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