The global monetary policy easing cycle is gradually kicking into gear with two major central banks cutting their official policy rate this month.

The Swiss central bank actually kicked off the global rate cut cycle with a rate cut in March, followed by the Swedish central bank in May. So far in June the Bank of Canada and the European Central Bank (ECB) have both added impetus to the global easing cycle by each cutting their policy rate by 25 basis points this month.

A broadening easing cycle across the global economy is, all things equal, a tailwind for global asset markets, however, the Fed policy cycle will be the key to animal spirits, in both bond and equity markets.

From this perspective, recent key data releases in the US have driven considerable volatility in interest rate expectations. The May labour market data released earlier this month saw expectations for interest rate cuts pared back significantly as job creation surprised to the upside. 

While near term interest rate expectations and long bond yields jumped, the US equity market took the release in its stride. This was likely on the basis that equities took comfort from the ongoing resilience of the US economy, even if rate cut expectations were wound back.

Adding to recent interest rate expectations volatility, last week delivered a much lower than expected May US CPI print. The headline CPI increased just 1 basis point (Bloomberg consensus 12bp) with 12-month CPI inflation slipping to 3.3% as energy prices (mostly gasoline prices) declined significantly.

Core CPI rose only 16bp in May, another step down following the 29bp increase in April after the strength in the first 3 months of the year (39bp in January and 36bp in February and March). The core CPI increase in May was also well below the consensus projection (28bp). 12-month core CPI inflation eased to a still high 3.4% (from 3.6%) but is now down a very significant 3.2% from its peak in September 2022.

This significant downside surprise on inflation drove a sharp decline in bond yields and a solid rally in equities, However, on the same day the Fed instigated a partial reversal of these trends with an unexpectedly hawkish policy statement and press conference.

As widely expected, the Fed kept its policy rate unchanged within a 5.25%-5.5% range in its June 12 meeting. However, the median FOMC member now expects to cut only once this year (from three times in the March projections). Board members pushed back one cut into 2025 (four cuts compared to the previous three). 

While this was a hawkish surprise, participants’ votes remain quite evenly split between one cut (seven participants) and two cuts (eight participants) this year. Four FOMC members expect to keep policy rates unchanged until next year.

Although Chair Powell acknowledged the softer-than-expected CPI release, he reiterated that inflation on balance “remains too high” and the FOMC needs “greater confidence” before easing monetary policy. 

When asked during the press conference about the Fed’s course of action if inflation were to remain sticky, Chair Powell continued to downplay rate hikes, and merely stated the Fed remained “prepared to keep policy restrictive”.

In our view, two cuts remain a plausible scenario for this year. The nearly even split between FOMC members anticipating one and two cuts suggests that a very much data-dependent Fed could ease more this year than its new median projection, if the recent disinflationary trends in the US economy extend over the next few months, as we expect. We note that there are still three more CPI prints before the September
18 meeting. At the moment the market is still priced between one and two cuts for this year.

Ultimately, whether the Fed eases one or two times this year will probably not make a huge difference to equities and indeed even the 10-year bond yield. The key will be if markets continue to believe that inflation is heading back to within range of the Fed’s 2% target, while the economy continues to expand at a respectable but controlled pace. This will keep medium term bond market pricing anchored on multiple cuts through both 2025 and 2026, while equities will also take comfort from the overarching soft landing narrative.

While historically rare, such a “soft landing” scenario is looking increasingly likely, in our view. This is typically a good news story for both equity and bond market performance. While US equity valuations are no bargain, we see relatively sound reasons as to why valuations are elevated versus historical averages. The structural growth outlook for mega cap US corporations (mostly tech) looks very positive, balance sheets are in great shape and cash flow generation is very strong. Our base case is the multiples contract over the next couple of years, resulting in less spectacular US equity returns, but stay well above long term average levels, providing inflation remains in check and the US/global economy continues to expand.

From a tail risk perspective, we do harbour some concerns around the path of US fiscal policy over the medium term. It is possible the US fiscal position could develop into a key pressure point as early as next year depending on the outcome of the US election (Trump is likely to make the deficit even worse). At this juncture the market appears relaxed in respect of the US deficit being more focused on the monetary policy cycle and the achievement of an economic soft landing over the next six to 12 months. However, market narratives can shift, so we remain constructive but watchful.

Closer to home, the RBA will be in no hurry to ease its own policy rate with inflation still well above the top of its 2-3% target range and the unemployment rate sitting close to record lows. At the same time a rate rise remains unlikely with economic growth now slowing to a crawl. Sluggish economic growth and (eventually) a moderate rise in the unemployment rate should bring inflation down toward target over the course of this year and next. 

The RBA should be able to ease policy some time in the first half of 2025, in our view. This is a significant lag compared to other central banks, but Australia will ultimately join the global easing cycle next year, albeit, somewhat belatedly. Equities (up) and bond yields (down) are likely to follow the global trends, but these trends should be more mild. Given the RBA will be slower to ease, the A$ should be on the strong side.