Is central bank dovishness fading?
Fed signals potential completion of rate cuts
The Fed’s rate cut at the end of October was the latest installment of a global dovish push this year with the goal of extending an already-long economic expansion. Yet the late-cycle easing may end soon. The Fed also signaled the potential completion of the rate cuts, significantly raising the bar for additional easing, in our view. What might be behind the move? A potentially tricky combination of slowing growth and inflation creeping higher; and the prospect for firmer growth in 2020 as easier financial conditions filter through to the broader economy.
Many central banks have switched gear this year. See the chart above for the net number of central banks cutting rates. Among them, the European Central Bank cut rates in September for the first time since 2016 and announced a restart of its asset purchase scheme; Brazil’s central bank has cut its benchmark rates to a record low at the end of October. But some central banks, including the Fed, may be closer to the end of this easing cycle. The Fed signaled a shift to a more data-dependent approach, and we now see a much higher hurdle for it to cut rates again in coming months. Markets are now pricing in just over one quarter percentage point rate cut in the coming 12 months.
One key reason for the Fed to end its late-cycle easing: The U.S. economy has held steady as robust consumer spending helps offset weakness in manufacturing activities and business investment. Third-quarter gross domestic product (GDP) grew at a better-than-expected 1.9% on an annualized basis, just below 2% in the second quarter. U.S. job growth slowed less than expected in October, underpinning the resilience in consumer spending. Looking ahead, there are some tentative indications that the deceleration in manufacturing may be ebbing. We see no signs of a meaningful turnaround in growth yet, but expect easier financial conditions – the result of an easing in monetary policy and a potential lull in trade tensions – to filter through to the broader economy over 6-12 months. As a result, we see only limited risk of a U.S. recession over the next year.
The dovish pivot by central banks – a key investment theme featured in our Global investment outlook – has supported risk assets. Yet this is a 2019 story. It is unclear whether further monetary easing would be the best remedy for shoring up slower growth in the U.S. or the euro area, in our view. We also believe monetary policy alone won’t be able to address the next economic downturn, as it is increasingly exhausted with interest rates nearing zero or even below in many developed markets – and weak inflation expectations dragging on actual inflation.
We maintain our overweight in U.S. equities and our neutral view on U.S. corporate credit. As credit remains part of our income thesis and we see only limited recession risks in the U.S., we feel comfortable holding both investment-grade and high-yield positions into the year-end.
What would it take to change our view? An unexpected tightening in financial conditions that leads to a spike in recession risks. Geopolitical frictions have become a key driver of the global economy and markets, but so far, we do not see it alone as sufficient to tip the U.S. economy into a recession, especially in the absence of major financial imbalances or systemic vulnerabilities. That said, the U.S.-led protectionist push has injected additional uncertainty into business investment decisions, threatening to weaken economic activity. We stress the importance of building portfolio resilience in this environment and see government bonds remaining important portfolio stabilizers – even at today’s low yield levels.
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