Central banks usually lower rates when there is evidence of a downturn in the economy. But the Federal Reserve’s latest interest rate cut was primarily a preventative measure.
This week (31 July), the Federal Reserve announced its first interest rate cut (by 0.25%) in 11 years, a move that should help prolong the longest US bull market in history.
Fed chair Jerome Powell cited the threat to global growth alongside continued low inflation in the US as the reasons why action needed to be taken.
The cut had been generally expected, with the Federal Reserve’s update in June being taken as evidence of it taking a more dovish approach.
In turn, this caused both US equities and bonds (US and otherwise), to enjoy a rare joint rally.
The hope of rate cuts caused investors to continue to pile into equities, which relative to cash become more attractive when interest rates are low or indeed reduced.
At the same time, bonds prices surged ahead in anticipation of monetary easing (interest rate cuts generally push up the price of bonds), causing bond yields around the world to fall to new unprecedented levels. The rally was also helped by the increased likelihood of the European Central Bank restarting its quantitative easing programme and potentially cutting rates further.
UK retail investors, it seems, were also getting in on the action, according to the Investment Association’s latest monthly fund flow figures.
In contrast to the £474 million withdrawn by investors from equity funds as a whole, North America funds were in the black, with net retail sales of £265 million.
Asia funds and global funds also saw positive inflows, of £68 million and £7 million, respectively.
In contrast, UK funds leaked £744 million, while Europe and Japan funds were £124 million and £19 million in the red.
Fixed income funds (bond funds), however, were the best-selling asset class of the month, with £2.4 billion invested.
Mixed-asset funds also proved popular, with £417 million pumped in.
Whether this equity and bond rally can continue remains to be seen. Immediate reaction to the Federal Reserve’s announcement was not entirely positive, with the US market falling slightly, while US 10-year bond yields have edged up.
Part of the problem was that a cut of some sort was already so widely anticipated that it was “already in the price”, as the saying goes.
Markets, it seems, would have required something more aggressive – either a bigger cut or more dovish guidance signalling a round of future cuts.
Instead, Powell suggested that the Federal Reserve’s decision was not necessarily part of a renewed campaign of rate cuts, instead referring to the measure as a “mid-cycle adjustment.”
However, despite the slightly muted response from market, the decision to cut is likely to keep markets broadly happy for the time being. As Olivier Marciot, investment manager at Unigestion, notes: “Momentum should persist as positioning does not seem extreme yet and leaves room for another leg of positive returns.”
However, that sentiment could quickly reverse in the face of certain ‘trigger’ events, such as an unexpected decline in US company earnings or an escalation of the trade war with China.
Added to this, the Federal Reserve’s decision to cut rates now, without any clear evidence of weakness in the US economy, adds a new risk. Historically, central banks weaken rates when there is clear evidence of the start of a downturn in the economy. Powell made clear the cut was a primarily a preventative measure.
But with interest rates already at historic lows, this leaves the Federal Reserve with less firepower (ability to lower rates), when an actual downturn does come about. And if there is one constant in the history of capitalism, it is that all booms eventually come to an end.