The Cutting Edge for Rates

Cuts Are Coming! After two rough years combating inflation through higher interest rates, global central banks are finally beginning the rate cut process! How will this developing trend impact your investment portfolio in the coming months?

Early this morning, the Bank of Canada (BOC) reduced its overnight interest rate target by 0.25% to 4.75%, the bank’s first cut in four years and the first instance of a G7 nation adopting looser monetary policy in the post-COVID era.

While the Canadian consumer price index (CPI) for the month of April came in marginally above the bank’s long-term target of 2%, the BOC cited “continued evidence that underlying inflation is easing” in justifying its initial round of cuts.

Despite widespread uncertainty about when America’s Federal Reserve will cut interest rates, with one audacious Barron’s headline released this weekend even claiming there will be no cuts in 2024, interest rate reductions from the BOC were the base case scenario for this meeting: swap markets had priced in an 80% chance of their occurrence.

Tomorrow, the European Central Bank (ECB) is set to announce its interest rate target for the month ahead, and market participants are near unanimous they will be cut, pricing in with 96% certainty that the ECB’s rate target will be reduced by 25 basis points.

Falling risk-free rates globally amid resistance to cuts from the Fed increase the attractiveness of holding dollar investments, bolstering dollar strength that could potentially reignite inflationary pressures overseas and placing immense pressure on U.S. monetary officials to implement their own cuts in the near future.

 Western Bloc nations, particularly those belonging to the G7, exhibit extremely close policy alignment, meaning it is unlikely that the BOC and ECB would have made such major changes in policy without first consulting the Fed on when it intends to cut.

Although the CME’s FedWatch Tool indicates that there is little change for change in US interest rates until September, it is clear that global policy makers are coordinating on lower interest rates, illuminating the pathway towards an aggressive cutting cycle.

Bulls have been invigorated by the development, sending the prices of both stock indexes and crypto’s majors surging within inches of establishing new cycle highs, and while U.S. interest rate cuts remain largely unexpected from a seemingly hawkish Fed, this stance will is set to be reversed at the first sign of objectively troubling economic data.

Many data series already show the economic decline has begun, and when taken in combination with emerging global trends of easing monetary policy – particularly among key economic allies – surprise Fed cuts could be in store for next week.

During the Global Financial Crisis, Fed officials attempted to kickstart the deteriorating economy and stall out the stock market slide with a dramatic 0.75% rate cut on January 22, 2008.

While these cuts succeeded in producing temporary bullish tailwinds for risk assets, allowing the broad-market S&P 500 to rebound nearly 15% off its lows, unfortunately, they ultimately proved unsuccessful at yielding a lasting impact and the index’s price had halved by year end.

The need for policy makers to cut rates is a harbinger for impending economic trouble, and historically, the tools available to central banks have proved ineffective at stymying the economic downside they are intended to prevent.