The debate on the U.S. Federal Open Market Committee’s (FOMC) first rate cut is likely to start with 50 basis points (bps) given some softening in employment and inflation, or a more moderate pace which is in keeping with typical 25 bps patterns likely closer to their comfort zone. The primary reason to do more than 25 bps in September is that they feel they are well behind the curve.
On Aug. 5, in the midst of several calls for emergency rate cuts, the market was pricing a 50 bps cut. At Friday’s close, there was only a 30 per cent chance of 50 bps with 100 per cent chance of 25 bps. While there is no official FOMC meeting at Jackson Hole, Powell will give us some updated thoughts on Aug. 23 at 10 a.m.
As of Friday’s close, the U.S. futures markets were pricing in eight 25 bps rate cuts over the next year. That would take the overnight rate to 3.5 per cent; significantly higher than where inflation is at. We think that is too aggressive unless we see a harder economic landing.
The base inflation rates are likely to be higher than the two per cent level for a considerable period. The worst outcome would be for too much stimulus lifting inflation again. While we are not likely to see the same fiscal boost we saw in whatever administration leads the U.S. given existing deficits and growing cost of outstanding debt, the cost of debt financing will continue to grow relative to the size of the economy.
The Bank of Canada, having already cut 25 bps twice, has six more rate cuts priced in by mid next year. This seems a bit more likely as the Canadian economy is structurally weaker than the U.S. in terms of what has been driving economic growth in recent years and going forward.
While the markets have bounced from the panic of a few weeks ago, we should expect much more of a consolidation of gains versus a continued extension. Earnings expectations are likely far too high for the economic growth that is expected in the next few years. The bond market is telling us a hard landing is coming, but the stock market is telling a different story. For markets, companies more sensitive to falling rates should perform better in the next few years than growth oriented companies that are more fully valued.
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