The US Federal Reserve’s chunky 50bp interest rate cut will likely lead funds to flow from ‘safe’ assets such as US Treasury bonds and money market funds to riskier assets. Meanwhile, slowing growth should exert disinflationary pressure and help sustain a global rate cutting cycle. This backdrop underscores our constructive view on equities, European investment-grade credit, and precious metals.
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US yield curve normalising
The recent start of the US rate cutting cycle will likely cause money that is now on the sidelines to flow to other, riskier assets. During the two years of Fed policy tightening, many investors saw money market mutual funds, bank certificates of deposits (CDs) and US Treasuries as preferable to equities or credit. Now, as yields decline, some of this money will likely be reallocated to stocks and corporate bonds.
Large-cap growth stocks and those that pay good dividends look set to benefit from this flow of ‘cautious money’. Lower rates are also positive for small-cap stocks: these companies typically carry more floating rate debt and are thus more sensitive than larger companies to interest rate cuts. An inverted yield curve is a drag on their profitability and credit risk profiles, but a decline in short-term rates should improve their finances.
Since early September, the spread between 2-year and 10-year US Treasury bond yields has normalised and turned positive, ending two years of inversion. However, the spread between the 3-month and 10-year yields remains negative (Exhibit 1).
Impact of the Fed cut in Asia
US rate cuts should give Asia some liquidity relief as they reduce the depreciation pressure on the region’s currencies. With inflation lower in Asia, authorities there are well positioned to mirror US rate cuts. Indonesia and the Philippines have followed the Fed’s move by cutting interest rate by 25bp and banks’ reserve requirement ratios by 250bp, respectively.
China joined the chorus line of policy easing by announcing a few days after the Fed’s move bigger-than-expected stimulus to support sluggish economic growth.
The package includes cuts in key policy rates and the bank reserve requirement ratio, financing support for small- and medium-sized enterprises, property market stimulus, capital injections into state-owned banks, and the creation of a fund and a swap facility to help financial institutions to buy stocks.
Beijing doubled down on this package two days later by offering one-off cash handouts to people in extreme poverty ahead of the National Day holiday on 1 October.
The Hong Kong and Chinese stock markets reacted with significant rallies after the announcement. The new stimulus measures indicate that Beijing is increasingly aware of weakness in the economy and markets.
China’s latest stimulus not a cure-all
However, whether this is the turning point for the Chinese market remains to be seen. The stimulus package does not directly address problems with consumer confidence and property market inventories.
Crucially, assertive fiscal easing measures are absent. The cash handouts to consumers are too small to have any macroeconomic impact. Only around RMB 150 billion was budgeted this year for extreme poverty alleviation (fewer than five million people fall under that definition).
Japan’s experience in 2010-12 showed that measures to boost equity purchases would not turn the market around without improvement in the macroeconomics. The Bank of Japan bought exchange-traded funds (ETFs) in each of those years, but there was no sustained improvement in investor confidence.
China needs to continue its easing efforts for longer to turn around investor sentiment and the economy. Indicators to watch for include stimulus programmes over the next three months, stability in property market transactions and prices, and a recovery in consumption, private-sector investment, and the credit impulse.
Even with the new stimulus, it is hard to imagine a quick turnaround in economic activity as the impact of the policy changes will take time to filter through.
Thus disinflationary pressures are likely to continue at least into the first half of next year. By the end of the second quarter of 2024, China had experienced five quarters of deflation (as measured by the GDP deflator), marking the longest period since the late 1990s (Exhibit 2).
This has had a global market impact: China’s underlying excess capacity means it will continue to export disinflationary pressures, especially to developed market trading partners.
Some analysts estimate that China’s deflation contributed to lowering core inflation in the eurozone and the US by about 0.1 percentage points and core goods inflation by about 0.5 ppt.1 Even if it is only by a small amount, it matters because the European Central Bank and the Fed are trying to squeeze out the last few tenths of a percentage point of inflation; the ‘last mile’ of reducing price pressures is thought to be the most difficult to achieve.
The ECB recently revised up its core inflation forecast by 0.1 ppt for 2024-2025 based on stubborn services inflation. Annualised three-month core PCE inflation in the US is about 1.9%. In this context, while the pass-through of China’s deflation to core inflation in the eurozone and the US is small, it is relevant in terms of increasing monetary policymakers’ ability to cut interest rates.
References
1 Morgan Stanley, “The Weekly Worldview: Why China’s Deflation Matters”, 16 September 2024
