Financial markets are kicking off a new month in an ebullient mood after the Federal Reserve left interest rates unchanged and Chair Jerome Powell suggested the central bank is prepared to cut them in September if inflation keeps moving lower. Treasury yields are lower across the curve, equity futures are consolidating for another day of gains, and commodity prices are broadly higher. On foreign exchange bourses, price action is more mixed, with a generalised improvement in risk appetite intersecting with still-elevated geopolitical tensions to alleviate selling pressure on the greenback: the Canadian dollar is holding steady while most other majors are trading on a weaker footing.
The British pound is the biggest mover on the major-currency board, down roughly half a percentage point after the Bank of England kicked off its long-awaited easing cycle. After headline inflation fell to 2 percent on a year-over-year basis in May and held there in June, the Bank’s Monetary Policy Committee this morning voted by a 5-4 margin to cut rates in a “finely-balanced” decision that might be best characterised as a ‘hawkish cut’. In both the statement and the post-decision press conference, officials warned markets against thinking that additional moves would come at consecutive policy meetings, with Governor Bailey saying “key indicators of inflationary pressures remain elevated,” necessitating a meeting-by-meeting approach to easing rates in the months to come. Ahead of the decision, markets had placed roughly 60-percent odds on a cut, and overnight index swaps are pointing to a quarterly pace of easing over the next year.
As has become traditional, yesterday’s Fed press conference was significantly more dovish than the decision itself. The official statement was less accommodative than many market participants had hoped, with relatively minor revisions made to language acknowledging progress on inflation and outlining risks to both sides of the central bank’s dual mandate. Markets initially sold off, but pivoted when Chair Jerome Powell began discussing the economic outlook with reporters, saying “A reduction in our policy rate could be on the table as soon as the next meeting in September,” while noting that a “real discussion” had taken place around the possibility of cutting earlier. Front-end Treasury yields tumbled and the dollar added to its losses as a front-loaded cycle—in which rate cuts are delivered in rapid succession—became more likely.
Markets now expect the Fed to deliver a quarter-point rate cut at each consecutive meeting through the autumn months, with another three coming in the first half of next year.
But a lot could change between now and the September meeting. With another two sets of inflation reports and two non-farm payrolls numbers, along with a slew of other economic indicators set to land in the interim, we suspect that overly-dovish interpretations of yesterday’s communications could be short-lived.
To wit, expected outcomes in the US election have shifted dramatically since President Biden stepped aside and Kamala Harris emerged as the presumptive Democratic nominee in late July. Prediction markets are now assigning 54-percent odds to a Democratic victory, up sharply from 36 percent only three weeks ago, and the likelihood of a Republican sweep of both houses of Congress and the executive has plunged. The last vestiges of a “Trump trade” in financial markets—if one ever existed—have largely been wiped out, with yield curves flattening as demand for hedges against a stagflationary economic environment recedes.
The shift in US electoral fortunes is helping support the Mexican peso, but a collapse in carry trade flows is largely offsetting any gains. The currency has come under renewed selling pressure in the last few days, with the Bank of Japan’s decision to raise interest rates and cut bond purchases boosting funding costs in the yen, and disappointing gross domestic product numbers supporting calls for firmer monetary easing guidance at next week’s Bank of Mexico meeting. Yen-funded carry trade returns remain positive on a year-to-date basis, but only barely so, and speculators are growing increasingly reluctant to enter a type of transaction that has long been described as akin to “picking up nickels in front of steamrollers”. We still think speculative appetites will return, but it is, admittedly, getting harder to justify that view, and the typical seasonal lull in global financial volatility is rapidly approaching its conclusion.
