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On 18 September, the Federal Reserve (Fed) delivered an interest rate cut as widely expected. As some (but not all) forecasters had foreseen prior to the move, the Fed cut overnight rates by 50 basis points (bps); as of 17 September, only 41 bps of the 50 bp cut had been priced into Fed Fund futures. Additionally, in its summary of economic projections, the median projected Fed Funds rate was revised sizably lower from 5.1% to 4.4% by year-end, implying an additional 50 bps of cuts within 2024 and a further 1% of easing in 2025. Following the meeting, the bond market priced in a more dovish scenario than foreseen by the Fed median. For the end of 2025, it priced a year-end rate below 3%, versus the Fed’s median of 3.4%. The bond market appears to have discounted Chair Jerome Powell’s warning not to interpret the Fed’s 50 bps cut as the “new pace” of easing this cycle. Note as well that although the Federal Open Market Committee (FOMC) modestly downgraded its forecasts for core inflation, core PCE is only forecast to reach the Fed target of 2% in 2026. Given that much can happen in this interim, it may be interpreted that the Fed’s trajectory is also far from set in stone.

Fed’s cut seen as an insurance policy

The Fed’s 50 bps cut demonstrated the power of financial conditions—and hence, financial markets at present. Easy financial conditions, including plentiful appetite for investment in equities and other risk assets, have played a key role in extending the US expansion cycle, which the Fed most likely did not wish to ignore. As the markets had already priced in a significant probability of a 50 bps cut before the actual easing, the Fed could have viewed such conditions as a good time to “buy insurance” and implement a 50 bps cut while the markets were likely to absorb it well, in case conditions were not so amenable in the future.

Prior to the cut, we had maintained that economic data warranted a more measured pace of easing. As such, we did not signal a 50 bps cut. Fed Governor Michelle Bowman, who voted against the 50 bps cut, also voiced such an opinion. This probably explains Powell’s seeming warning to the markets to view the initial cut as an exception rather than the norm. While the US unemployment rate has moved higher and the FOMC median expects it to rise to 4.4% by year-end (versus 4% in June), the labour market has not demonstrated the type of deterioration that would merit accelerated cuts (see Chart 1, which shows current year-on-year nonfarm payrolls remain above levels typical of an economy slipping into recession).

Chart 1: US non-farm payrolls year-on-year

Source: Nikko AM, BLS

Risks are not uniformly to the downside for the US and therefore Fed Funds

Should the outlook deteriorate further, another cut could come sooner rather than later, but Powell’s rhetoric indicates that a 25 bps cut is likelier than a 50 bps one in the absence of significant deterioration.

We emphasise that the uncertainty surrounding the US election is also likely to contribute to ambiguity surrounding the Fed’s policy trajectory. But the risks during and after the election may not be to the downside. Both presidential candidates, after all, are putting forward different types of protectionist rhetoric, particularly concerning trade with China, and protectionism is typically inflationary. Likewise, neither candidate (at least at present) supports a platform of fiscal consolidation. Expectations of tax cuts and/or spending hikes could be inflationary. If inflation expectations rise regardless of which candidate is elected, it is in the Fed’s mandate to react; if such expectations are strong enough to prevent inflation from proceeding smoothly toward the 2% target, the argument will be for the Fed to refrain from cuts until inflation is back on track toward its target.

Don’t fight the Fed in the short term, secure insurance

For now, the Fed can afford to humour financial markets. The “neutral” rates, which many forecasters estimate to be somewhere between 2.5% to 3.5%, are lower than where we are now. This allows some additional room for the Fed to cut rates in the name of normalisation, rather than as a form of outright stimulus. However, the market appears to be keener on rate cuts than the Fed itself. We have already seen the bond markets largely pre-empt the Fed’s rate cut, so the potential for bond duration to increase was limited after the fact. There could be a similarly limited short-term upside when the Fed acts again. Yet after the Fed delivered its 50 bps cut this time, the yield curve appears to be discounting Powell’s warnings to the bond market to temper its expectations. As such, the risk of a disappointment at some point over the next few months (when anticipated rate cuts do not materialise) has risen.

Insurance against fiscal risks and interest rate volatility

Negotiating the debt ceiling will be one of the first tasks of the next US president. As we previously mentioned, neither candidate is supporting a platform of fiscal prudence, and Congress has, in the past, tended to raise the debt ceiling as long as political motivations of the negotiating sides are satisfied. If negotiations do not involve greater fiscal discipline, there may be a heightened risk of dislocation in the bond markets due to actions from the US’s overseas creditors. Ultimately, double deficits mean that the US must strike a balance between offering enough stimulus to keep the domestic economy growing and high enough interest rates to keep foreign investors interested in bidding at bond auctions. Compared to many of its trade partners, there might not be an immediate threat to the US from higher rates of interest. However, as interest rate differentials narrow (and currencies become more volatile), the risks associated with the combination of fiscal expansion and rate cuts may heighten. In this light, it may be beneficial to secure protection against extreme moves in long-term interest rates. While volatility is still higher than it was a few months ago, it has calmed down from its peak. Having protection against sudden spikes in long-term interest rates could prove to be valuable.

View that AI has made the US economy more dynamic yet to be realised

It is hard to argue that technology in the US will not, at some point, increase the country’s productivity. The trouble is, despite the dominance of big tech in US and therefore global stock indices, such productivity growth has not yet materialised. US total factor productivity, which had seen healthy growth well above 5% year-on-year on average in the early 2000s, now languishes below 1% (even despite over a decade of ultra-low rates). If the US is to grow and thus inflate its way out of debt, productivity growth should and probably can be higher (see Chart 2, which shows the 10-year mean of US productivity growth at similar levels as that of Japan, which recently emerged from 30 years of stagnant growth and deflation).

Chart 2: US, Japan total factor productivity (constant prices, USD)

Source: Nikko AM, Long-Term Productivity Database

The US has made such transitions before (e.g. the 1970s and 1980s, when inflation, rates and taxes were higher). This said, taking advantage of such a shift also probably means taking active risk again. Names that are most in vogue today may not necessarily be the beneficiaries of this probable rise in US productivity. As we saw during the telecoms boom of the 1990s, those who build the infrastructure are not always the ones who ultimately reap its greatest benefits in terms of profitability. This means actively selecting firms across all sectors for firms who are likely to deploy technology or invest in the correct human capital to outpace their competitors. We may find that as we get further into the cycle, beta is a fickle friend and alpha favours skilled active stock pickers.