The reaction of financial markets to the current rickety state of the world could perplex, or even shock, investors. Do we need to wheel out that corny stock market adage: ‘buy at the sound of cannons’? It may be better to try to get away from the increasingly worrying geopolitical news and fragile situation in the Middle East to draft a scenario with a shelf life of more than a few hours.
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Since the beginning of the year, trade policy, prospective fiscal measures and geopolitics have taken turns in dominating the news. To date, this ‘carousel’ has resulted in a modest gain for US equities (+1,7 % for the S&P500 index), a solid advance for European indices (+10 % for the Euro STOXX) and significant depreciation of the US dollar (-8.8 % for the DXY index).
Leaving aside US President Donald Trump’s abrasive rhetoric with regard to the US Federal Reserve Chair, monetary policy has not been a prominent force in markets. For much of 2024, the scenario of rapid monetary easing played a significant role in supporting equities before investors began to question whether the easing cycle would continue in 2025.
In developed economies, many central banks did cut their policy rates this year, but at a somewhat less sustained pace than in 2024: the Fed opted for the status quo in the first half of the year after a cumulative 100bp in rate cuts during the second half of 2024.
Since the spring, many central banks have adopted a more cautious stance, refraining from giving guidance on the outlook for rates and instead relying on ‘meeting-by-meeting’ decisions.
In emerging markets, monetary policy was supportive of economic activity and markets.
The Chinese authorities announced a wide range of easing measures:
- A cut in key rates including -50bp for banks’ reserve requirement ratio
- Liquidity injections
- An increase in refinancing quotas
- An unprecedented 25bp cut in a ‘structural monetary tool’ rate
- A cut in two key lending reference rates for the first time in seven months, pushing them to all-time lows.
Elsewhere in emerging markets, downside risks to activity and inflation (accentuated by the drop in energy prices) should pave the way for central banks to ease policy more quickly than they would have done without the protectionist trade policies of the US.
In the absence of uncertainty over trade, fiscal policy and the geopolitical outlook, these policy shifts would be occupying investors’ minds, and not just those of bond market investors.
A busy week for central banks
The Bank of Japan led the way. Its situation is special since, contrary to peers, the BoJ began a tightening cycle in March 2024, raising its policy rate from -0.1% to 0.5%. Nonetheless, its stance is cautious. Since January, it has held the policy rate steady while not excluding further tightening. It sees the tariffs on Japanese goods imported by the US as a downside risk to growth in Japan.
The BoJ has said it would continue to taper its monthly bond-buying, but has also announced that the pace of this ‘quantitative tightening’ would slow from April 2026 to enhance the functioning of the Japanese bond market after the 30-year JGB yield set an all-time high close to 3.20% in May.
Both the Norges Bank and the Swiss National Bank cut rates by 25bp as inflationary pressures eased. With an SNB rate of 0%, investors may ask if Switzerland is on the way to a new spell of ultra-accommodative monetary policy. Given the country’s dependence on global demand and the strong currency, this appears to be a fair question.
The European Central Bank had already opted for a more cautious stance. After the fourth 25bp cut this year, the deposit rate is now at 2.00%, a level that the ECB says puts its monetary policy in ‘a good position’ to cope with possible (supply, trade…) shocks.
Its latest forecasts for growth and inflation, President Christine Lagarde’s recent comments, and a now comparatively dovish tone have led many investors to conclude that the ECB’s rate-cut cycle is ending.
The central bank of Sweden cut its policy rate by 25bp to 2.00% this week. Like several of its peers, it published two alternative scenarios for growth and inflation alongside its main scenario.
Both are negative on activity. 1) Disruption of global supply chains amid an escalating trade war would sap growth, but boost inflation and lead to higher policy rates. 2) A fall in economic agents’ confidence in the face of uncertainty could also weaken demand, but lower inflation, and allow for lower rates.
So, for Sweden, a good example of a ‘small open economy’, the outcome of trade negotiations between the US and Europe will be crucial. For now, the Riksbank is maintaining a downward bias by saying that ‘the forecast for the policy rate entails some probability of another cut this year’.
Here comes the Fed
Expectations of a rate cut in June had ebbed entirely after the news of a trade agreement with China. Futures markets quickly adjusted the number of expected 25bp cuts in policy rates to two (from four in early May) as many investors saw a US recession becoming less likely. Thus, it was no surprise to see the Fed hold policy rates steady at the 18 June Federal Open Market Committee (FOMC) meeting.
All eyes and ears were focused on Fed Chair Jerome Powell’s comments and the latest FOMC forecasts. The new projections for growth and inflation now incorporate the effects of the import tariffs: lower GDP growth and higher inflation, but nothing that could be seen as a warning signal so far. Indeed, Chair Powell’s analysis of the economic situation has remained rather positive.
On employment, he said ‘a wide set of indicators suggests that conditions in the labour market are broadly in balance and consistent with maximum employment’.
Reading his comments on inflation, we can see that Chair Powell is not a one-armed economist1: “Increases in tariffs this year are likely to push up prices and weigh on economic activity. The effects on inflation could be short-lived – reflecting a one-time shift in the price level. It is also possible that the inflationary effects could instead be more persistent… Avoiding that outcome [more persistent inflation] will depend on… on keeping longer-term inflation expectations well anchored.”
There appears to be no hurry to cut the policy rate. The Fed can wait and see until there is more clarity on the outlook for growth and inflation since monetary policy is ‘well-positioned to wait to learn more’. Powell defined the current policy rate as ‘modestly or moderately’ restrictive.
Looking at the quarterly dot plot – the FOMC’s list of projections and de facto forward guidance on future rates – the March edition had signalled two 25bp cuts in 2025. At the time, just eight FOMC members were thinking about holding rates steady or a single 25bp cut.
The latest dot plot still implies two 25bp cuts this year, but the FOMC is now split: nine members favour no cut or just one, but 10 think that two or three cuts would be appropriate. For 2026 and 2027, in line with the upward revision to inflation, median expectations were raised by 25bp.
The split makes the dot plot less efficient as a predictor of policy, also given what Powell described as the historically elevated uncertainty. This setup could advocate for meeting-by-meeting decisions.
Market-based estimates of the outlook for the fed funds rate have not changed dramatically since the FOMC meeting: they are still pointing to two rate cuts this year.
[1] President Harry Truman famously asked to be sent a one-armed economist, having tired of exponents of the dismal science proclaiming “On the one hand, this” and “On the other hand, that”.
