Different paths to the same destination

The Federal Reserve got their cutting cycle underway with a jumbo 50 basis point (bps) cut this week, but not all central banks are on the same path.

For one, the Bank of Japan is on a hiking path of its own. After holding rates steady as expected on Friday, Governor Ueda announced that further rate increases could be in store for the BoJ if their outlook is realized.

Meanwhile in Europe, the Bank of England and Norway’s Norges Bank stuck to their cautious approaches. Both central banks kept policy rates unchanged and signalled that any adjustments to rates from here would indeed be gradual in nature. That echoed what we heard from the European Central Bank a week earlier, where a 25bps cut came with a signal for quarterly reductions going forward.

After the September round of central bank meetings, the Fed is being priced as somewhat of an outlier by the market. In today’s note, we dig into the different challenges facing central banks and our views for the rate cutting cycle ahead.

The Federal Reserve has quickly adjusted its “higher for longer” stance earlier this year to a more aggressive pace of interest rate cuts. That has been justified by a steady decline in inflation and a softening in the labor market – which has brought the risks around the Fed’s dual mandate into better balance.

The September meeting also came with a new set of economic projections, which stuck to that script of continuing to lower interest rates at a faster pace over the next year. The median Federal Open Market Committee (FOMC) participant penciled in 50bps of further cuts across the remaining two meetings this year (likely 25bps at each), followed by 100bps of cuts in 2025 and 50bps more in 2026 to a terminal rate of 2.9%, where they see rates remaining through 2027.

The Fed has made its own path clear, and markets have adjusted to that. But as mentioned above, the narrative hasn’t been as clear-cut on this side of the pond.

Much of that can be attributed to the labor market. As the global economy has continued to expand, more jobs have been added to meet that demand. The difficulty facing central banks in the post-pandemic era has been that a lack of workers are available to fill new positions. In turn, that gives way to an overheating jobs market – where most people that want a job can get one and they are paid more for doing so. That upward pressure on wages has ultimately been a dominant driver of inflation pressures – and is something that central banks have focused on over the last year.

The U.S. economy has benefited from an influx of workers due to increased immigration and a considerable boost to the productivity of the labor force (i.e. fewer workers needed for the same output). Both of those factors have helped to cool some of that pressure in the labor market. The same can’t be said for Europe and the UK, which is contributing to stickier inflation even as demand has been slowing. Things have still been trending in the right direction towards central bank targets, but the path to lower rates looks set to be a slower one to combat those risks to inflation. As Governor Bailey noted, the Bank of England "need to be careful [to] not cut too fast or by too much." Absent a growth shock, we think that a quarterly pace of cuts from the BoE and ECB seems likely going forward.

The divergence in monetary policy stances among major central banks underscores the uncertainty in the global economy today. We continue to think that we are on a path towards a soft landing, but diversifying across regions and asset classes can help to smooth the ride through some of the macroeconomic volatility. One thing is consistent across these major economies, cash rates are headed lower. That adds urgency to the decision for stepping out of cash and into other investments. Our preferred ideas today include:

1. Bonds: With cash rates moving lower, longer-duration fixed income products become more attractive. Locking in yields now can provide stable returns as central banks continue to ease policies.
2. Structured Notes: These can offer downside protection while capturing upside potential, making them suitable for a market that has already rallied considerably.
3. Quality Equities: Focus on higher-quality companies that can weather economic fluctuations better.
4. Core Equities: Be prepared to buy on dips, especially if a soft landing remains the base case.
5. FX Diversification: Divergences in central bank policies have direct implications for currency markets. Implementing a balanced allocation across currencies dependent on your given needs can help to reduce the FX impact on portfolio returns.

For more details on our thinking or to discuss your portfolio, please reach out to your J.P. Morgan team.