Financial markets are reassessing the outlook for US interest rates not only because of stronger-than-expected US growth and inflation, but also because of a global recovery in manufacturing output. Green shoots are being seen worldwide despite Europe’s economic weakness.
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This raises two important questions:
- What is driving the recovery in manufacturing?
- Will it keep central banks from cutting interest rates? Could it even prompt the US Federal Reserve to raise them?
The current bounce-back in manufacturing could improve the outlook for growth and affect monetary policy in the coming months.
What is driving the recovery?
Global manufacturing, as approximated by the weighted average of the purchasing managers’ indices (PMI) of China, the US and the eurozone, has bottomed since late 2023 (see Exhibit 1). The eurozone’s PMI surprised the market by rising to 50.3 in March – the first above-50 reading, indicating expansion, in nine months.
There are three main sources of the reignition in manufacturing:
- The US economy has held up well despite 15 months of monetary tightening. A robust labour market and resilient consumer demand have boosted manufacturing output.
- The Chinese economy has finally responded to Beijing’s recent aggressive policy support, with electricity consumption growth, a more accurate indicator of economic activity, rising faster than the official GDP growth rate (see Exhibit 2).
- US-led manufacturing re-onshoring and de-risking away from China has boosted manufacturing activity in many Western economies. To counter this trend and address US-led trade restrictions, China has relocated production capacity to other countries, notably ASEAN, raising manufacturing output there.
Implications for Fed policy
The continued strength of the US economy and the recovery in manufacturing are prompting financial markets to reassess the course of US monetary policy, in addition to recent signs of sticky inflation. The Fed is no longer expected to cut rates six times this year, but only three times if not less. The first cut is no longer expected in June, but might now come in September. Some observers are even talking about the Fed tightening policy again.
The Fed’s dual mandate requires it to keep prices stable and maximise employment. These two objectives are often in conflict, leaving financial markets uncertain about the future policy path and its impact on asset prices.
What seems certain at the moment is that, as a risk-control strategy, the Fed is inclined to delay rate cuts if the economy remains resilient (note that March non-farm payrolls rose by a further 303 000), even when inflation should continue to move lower (though March headline and core consumer price inflation remained sticky at 3.5% year-on-year (YoY) and 3.8%, respectively).
Cuts to go ahead elsewhere
The story is different for other central banks. The Swiss National Bank recently cut rates as inflation in Switzerland dropped to 1% in March.
The Bank of Canada is expected to follow suit soon as core inflation excluding mortgage interest payments (which have recently surged) has effectively fallen to below 2%, with the economy running with excess supply, according to the central bank.
There is a high possibility that the European Central Bank could cut rates before the Fed does as inflation in the eurozone has dropped faster towards its 2.0% target and growth momentum is weaker than in the US. In its latest (11 April) monetary policy statement, the ECB’s governing council indicated that the time for the first cut might arrive soon. The market expects that to be at the June policy meeting.
Overall, we believe the rate cut story is intact, but the Fed is now expected to lag other central banks due to the different growth and inflation dynamics in the US. The means the US dollar could remain well supported until the Fed starts to cut, all else being equal.
The ECB’s relatively softer policy stance bodes well for eurozone bonds, or so thinks our multi-asset investment committee. The combination of a global manufacturing recovery, resilient US economy, and a revival of Chinese and Japanese growth suggests an improving outlook for equities beyond the short term.
But not in the APAC region
Asian central banks, however, are not likely to cut rates before the Fed due to the region’s reliance on US dollar liquidity. If the Fed holds off, Asian central banks will likely do the same. This will keep real interest rates high (see Exhibit 3) and could pose a downside risk to the region’s growth and asset markets.
The outlook for the region therefore looks cloudy to us.
Resilient US GDP and job growth with better supply-side dynamics due to increased labour supply (through migration) and productivity could allow the region to benefit from greater US export demand and the spillover to investment. This could offset some of the drag on regional growth from higher-for-longer interest rates in the US.
But rising inflation due to supply constraints might change that assessment.
