Interest rate cuts on horizon

By the OFX team | 11 September 2024 | 5 minute read

At the Economic Symposium in Jackson Hole, Wyoming, US Federal Reserve (Fed) President Jerome Powell fired the starter gun on a probable cut in US interest rates.

For the US economy, “public enemy” number one used to be inflation but with data confirming it is close to the 2% global target, Powell has a new target in his sights: unemployment.

“We do not seek or welcome further cooling in labour market conditions,” Powell said as he kicked off the annual meeting of central bankers¹.

With an unemployment rate sitting a full percentage point higher than a year ago and the job market “less tight” than pre-pandemic levels, Powell doesn’t see any risk of wage gains pushing up inflation. Instead, with inflation down to 2.5% and edging towards the Fed’s target range of 2%, he announced a policy U-turn.

“The upside risks to inflation have diminished. And the downside risks to employment have increased,” he said.

“The time has come for policy to adjust,” he said, flagging that the next move on interest rates will likely be downward².

US dollar drops as Powell heads for new territory

Chairman Powell’s speech dovetailed nicely with the Federal Reserve minutes from its July meeting, revealing that while board members agreed to keep rates steady in July, the weak jobs data had them considering a rate cut in September³. It’s affirming for markets to see that the Fed’s overall sentiment has remained largely unchanged.

Speculation around whether interest rate cuts could be a quarter or half a percent received more momentum following a survey of US manufacturers⁴. The survey showed a further decline in new production orders and a rise in excess stock, as current supply outweighs demand⁵.

On September 6, US payrolls data showed hiring grew at a lower-than-expected rate of just 142,000 jobs, making it the weakest 3 months of data since the mid 2020s⁶.

Powell’s change in approach, on top of recent economic data, has set off a red flag in the bond market.

The US yield curve could signal a recession

A tell-tale sign that a recession is imminent is when short-term interest rates become higher than long-term interest rates, which is unusual and can signal economic trouble.

It’s called a yield curve inversion.

It reflects that investors are nervous about the economy’s future, so they pile into long-term bonds, pushing those rates down, and the shorter-term rates stay higher which creates this “inverted” curve.

Historically, yield curve inversions have been seen as a warning sign of an economic downturn. The yield curve has been inverted for 26 months, without a recession, and has now come back to even.

Market experts say that the very fact the curve has crossed again could signal a recession is even more imminent.

According to Bloomberg’s World Interest Rate Probabilities function, which uses movements in the derivatives market to predict where rates will go, traders are betting that interest rates will be cut at each Fed meeting all the way through into next year. Rates could ultimately fall to 3% from its current rate of 5.25%-5.5%⁷.

What could be next for the US dollar?

The US slowdown is not happening in isolation. Other nations are experiencing anaemic growth and they too are faced with the decision to cut interest rates rather than keeping them high.

In fact, cuts to US interest rates would likely be welcomed by central bankers in other jurisdictions.

A high US dollar actually hurts other nations because their comparatively low currencies makes it more expensive to buy goods from overseas. Effectively, they’re “importing inflation”.

That forces central banks to either intervene by buying up their own currencies, or keeping their own interest rates higher for longer than is appropriate for domestic economic conditions.

US interest rate cuts may kick off a wave of cuts elsewhere as other countries, particularly in emerging markets, get some much needed “breathing room”.

“Through the remainder of the year, we expect central banks in Philippines, Singapore, South Africa, South Korea, Taiwan, and Turkey to join their early-cutter peers in LatAm and (central and Eastern Europe),” Mitsubishi UFJ Financial Group’s (MUFG) head of emerging market research, Ehsan Khoman told Reuters⁸.

So it may mean the US dollar’s downward run against many currencies won’t last for too long. In the short term, it is likely to continue to decline, relative to the euro.

At the Jackson Hole Economic Symposium, Philip Lane, a member of the European Central Bank’s board, said the job on inflation is not yet over.

“ECB monetary policy has been effective in dampening demand and stabilising inflation expectations, underpinning a timely return of inflation to the target,” he wrote in his presentation.
But he warned they were not there yet and a “Restrictive stance (is) still appropriate.”⁹

That should help the euro hold its value for a while at least.

All eyes on the global economy

Many countries are worried about growth.

China’s economy grew by just 4.7% in the second quarter, with future growth forecasts sending this month’s yield on China’s benchmark 10-year government bonds to a record low. That’s a sign the market predicts the People’s Bank of China may cut interest rates to shore up growth.¹⁰

Another sign is China’s unused inventory of iron ore. Iron ore fell by 7% in September and is now down to US$91. Quite a change from US$147 in January¹¹. That shows that construction and infrastructure demand is weak.

As Australia’s main export is iron ore, the commodity’s weakness is tied to Australia’s economic strength, and local growth is effectively at a standstill¹².

Crude oil has also slumped to its lowest level this year as demand dries up¹³, and stock markets are flashing warning signs of potentially large selloffs¹⁴.

Carmakers in Europe are cutting back production, with Volkswagen mulling closing car plants due to cutthroat competition and weak demand¹⁵.

Against their global peers, the US is still looking remarkably robust.

What this could mean for currencies

With a few economies showing lower than expected growth, suspected recession for others and a downtrend for more than one commodity, global markets are expecting larger fluctuations across the major currencies.

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