Macro & Strategy - October 2024

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It cuts like a knife

After the 50-basis-point cut by the U.S. Federal Reserve on September 18, the central banks of developed countries are now officially in a synchronized rate-cutting cycle. This shift follows the unprecedented, synchronized cutting and then hiking cycles of the COVID-19 pandemic, and the normalization of global inflation that ensued.

In our view, we are entering the final phase of the post-COVID period, which started in 2021 and will most likely end toward mid-2025. It’s characterized by generationally high inflation, tight monetary policy and the eventual cooling-off that is still unfolding at this writing.

Looking back, we see that the disinflationary pressures of the past 24 months in Canada and the United States have been driven more by the normalization of the global supply chain, an increase in the labour supply in North America (mostly from immigration in Canada) and a boost from a rising participation rate and booming U.S. productivity. As we enter the final quarter of 2024, it seems obvious that monetary policy is much too restrictive and that central banks are on a set course back to the neutral rate, which is 2.5% to 3% in both countries.

On the other side of this cutting cycle, a brand-new economic cycle awaits. It should emerge not from the ashes of a recession, but more likely from a U.S. economy that appears to be close to equilibrium, with stagnating economies in Canada, Europe, Japan and China.

The Coming Synchronized Cutting Cycle: What’s Priced In?

The market has already priced in several rate cuts over the next year, expecting a shift from inflationfighting policies to growth-supporting policies. The synchronized nature of this cutting cycle – expected to involve multiple major central banks – adds an important layer to the narrative. In contrast to previous cycles, when monetary policies often diverged across regions, this time we are likely to see a globally coordinated response.

As we exit the post-COVID period, probably in the second half of 2025, we will transition into a new business cycle, and our focus will shift from managing inflation to navigating slower growth. This environment will create a unique set of challenges and opportunities for markets and policymakers alike.

Historical Analysis of Fed Cutting Cycles

To better understand the possible trajectory of the coming cutting cycle and its potential impact on markets, it’s instructive to examine previous Fed cutting cycles.

Historically, these cycles have been driven by a mix of macroeconomic forces, including growth slowdowns, inflationary pressures, and financial stability concerns. This time, we find the U.S. economy in a solid position, although it is normalizing at a pace that requires careful managing from the Fed.

Using Fed fund-rate data going back to 1928, we have looked at each of the Fed’s 22 major cutting cycles and what was priced in at the time. Given limited data availability, we had to resort to a proxy on market pricing, because the Fed funds futures market wasn’t introduced until 1988. We chose the next-best option, namely the 2-year Treasury yield, for which we were able to go back to 1940 using GFD data, giving us 19 cutting cycles to work with.

The idea behind this proxy1 is simple: the differential between the 2-year yield and the Fed Funds rate reflects, at least partially, the market’s expectation of rate cuts. A larger spread suggests that the market is pricing in more aggressive cuts, because the 2-year yield captures expectations for the Fed’s average policy rate over the next two years.

This proxy is not precise enough to determine how many basis points of rate cuts were priced in at each juncture, so we settled on a rule of thumb: whether the spread at the decision date is wider or tighter than the median historical spread.

More precisely, we calculated that the median spread between the 2-year yield and the Fed funds rate at the beginning of cutting cycles was -98 bps. Anything lower is considered expectation of an aggressive cutting cycle, whereas anything higher is considered expectation of a shallow cutting cycle.

The same logic applies to the characterization of the cutting cycles themselves. We find that the median size of cutting cycles in the sample is -365 bps. Anything lower than median is considered an aggressive cutting cycle, while anything higher than median is seen as a shallow cutting cycle.

The table below shows that, in 12 of the 19 instances after 1940 (for which we have data on U.S. 2-year rates), the Fed delivered the type of cutting cycle that was initially priced in by the market In five instances, the Fed overdelivered, and only twice did it underdeliver.

How the Fed’s Actions Compare with Market Expectations

The extent to which the Fed meets or exceeds expectations can have a profound impact on financial markets.

We can categorize these dynamics into three scenarios:

1. The Fed Delivers What’s Priced In (12 out of 19 cycles)

In the most common scenario, the Fed delivers the type of cutting cycle expected by the markets. This scenario tends to be the most favourable for equities, positive but similar to the full sample median for fixed income and cash, and unfavourable to gold.

A prime example would be the Fed’s 1995 cutting cycle, when we saw a brief and targeted response to concerns over slowing economic growth despite relatively stable inflation. After a series of rate hikes in the early 1990s aimed at cooling the economy, the Fed pivoted in July 1995 and initiated a small rate-cutting cycle.

Over six months, the Fed cut rates by a total of 75 basis points, bringing the federal funds rate down from 6% to 5.25%. The cuts were primarily pre-emptive, intended to sustain the economic expansion without letting inflationary pressures build. The market reacted positively, with the S&P 500 Index rising and bond markets rallying as the Fed acted to prolong the business cycle. This cycle is often seen as a successful example of the Fed’s use of monetary policy to engineer a soft landing for the economy.

2. The Fed Exceeds Expectations (5 out of 19 cycles)

In the second-most-common scenario, the Fed overdelivers, generally during recessions and/or financial crises. Our historical sample shows that overdelivery by the Fed tends to be welcomed by markets, especially fixed income and gold. Equity performance tends to be more volatile, and the median is a bit lower than the fullsample median.

The prime example of such a cycle would be the 2007-2008 crisis, when the Fed acted with a dramatic and aggressive response to the unfolding Global Financial Crisis.

Initially, the market expected moderate cuts, but as the crisis deepened, leading to the failure of major financial institutions, such as Lehman Brothers in 2008, the Fed slashed rates more aggressively. During the cycle, the Fed lowered the federal funds rate from 5.25% to almost zero (0-0.25%) by December 2008, for a total of 500 basis points of cuts. Despite these efforts, equity markets plummeted, with the S&P 500 experiencing a historic downturn, while bond markets and safe-haven assets, such as gold, saw significant inflows as investors sought stability during the economic meltdown.

This cutting cycle was one of the most intense in the Fed’s history, marking the beginning of an extended period of monetary easing and unconventional policies, such as quantitative easing (QE). The largerthan-expected easing initially caused panic in equities, but long-term government bonds and gold benefited as investors sought safe-haven assets.

3. The Fed Underdelivers (2 out of 19 cycles)

In the final scenario, the Fed underdelivers

According to our historical study, the Fed has underdelivered only twice: in 1973, when the OPEC oil embargo created stagflation, prompting the Fed to cut less than expected to keep inflation in check; and in 1998, when the Fed acted pre-emptively, given the turmoil in emerging markets, and continued with two additional cuts in response to the LTCM crisis.

The reactions from equities in these instances stand in stark contrast: very negative returns in the 1973 episode and strongly positive returns in 1998. The reaction of fixed income and gold, on the other end, was negative in both episodes.

Conclusion: Where do we stand now?

The current situation indicates that the market is expecting an aggressive cutting cycle from the Fed, which, as noted, has historically meant more than 365 basis points of cuts. Our reading of the current U.S. economic backdrop suggests that the Fed is unlikely to deliver that much easing in the coming cycle, because we find the risks of a recession sufficiently low.

We would thus expect the cutting cycle to be shallow, maybe even more so than the median of the nonrecessionary cycles, which stands at 313 basis points of cuts. Our best bet is that the Fed will cut rates to about 3% by the end of 2025, where our estimate of neutral stands, for a total of 250 basis points. Thus, the coming cycle will most likely belong to the underwhelming category.

Given that we don’t see a stagflationary environment unfolding, we tend to give more credence to the 1998 episode as a reference point; equities (large and small caps alike) and cash offered positive returns, but the returns on fixed income and gold were negative.

As we enter this new cutting cycle, the historical record offers valuable lessons. Even though markets typically price in expectations based on the prevailing macroeconomic environment, the Fed’s ability to respond dynamically to evolving data is crucial. Whether the Fed meets, exceeds, or underdelivers in relation to what’s priced in will depend on future economic developments—particularly inflation, growth, and financial stability.

The global synchronized cutting cycle we're approaching carries unique risks and opportunities. Central banks worldwide will most likely move in concert, which could amplify the effects on financial markets and in all likelihood lead to better financial outcomes.

Current Outlook and Positioning

We are maintaining our overweight position in equities relative to cash, with a particular focus on Canadian, U.S., and emerging market equities. The current environment remains favourable for equities: growth is resilient, at or slightly above trend, and inflation is receding to target. Thus, central banks can provide easing from restrictive interest rate levels to more neutral or accommodative territory.

We expect China’s recent stimulus measures to feed risk appetite, with the People’s Bank of China establishing new funding facilities with a view to injecting liquidity that will eventually end up in the equity market. We think its measures will support the country’s ailing asset prices and revive investor sentiment toward China. These targeted measures are the most constructive steps China has taken in a long time to revive its struggling economy and market.

Meanwhile, we don’t think Western investors currently have heavy exposure to China: in the aftermath of the Russo-Ukrainian war and after two years of tepid Chinese growth, many investors have reduced their exposure significantly and are now underweight the country. We expect that the positive reverberations of the Chinese stimulus measures will extend to Asia more broadly, providing a favourable backdrop for Japanese equities. We also expect this global stimulus to lead to a broadening of equity market action, with more regions (other than the United States) participating and more sectors (other than U.S. large cap tech) also benefiting.

We also continue to hold an overweight position in bonds relative to cash with a focus on the long ends of the Canadian and U.S. yield curves. With inflation finally showing signs of returning to target, the Fed and the Bank of Canada can potentially provide support to the economy with rate cuts. From a portfolio construction perspective, this increases the value of bonds and duration, because such assets can hedge equity risk effectively.

Our view on bonds turned positive during the summer and has continued to improve as statements by central banks and incoming data have further supported our change of view. We expect bonds to play a greater role in portfolios going forward.

Finally, we see the current macro environment as conducive to a weaker U.S. dollar. Growth near trend, along with an accommodative Fed and a global wave of stimulus, has historically tended to push the greenback lower. We are under-weight the U.S. dollar and instead favour other G10 currencies, such as the British pound, the Swiss franc and the Japanese yen. We also think the weak U.S. dollar provides a favourable backdrop for gold.