Financial markets continue to make new highs as central banks cut interest rates globally.

In the US, the Fed surprised by reducing its fed funds rate by 50 basis points (bps) in September from 23-year highs of 5.25-5.50%. Officials have become less concerned about inflation as consumer price rises have fallen closer to the Fed’s 2% target. Instead, the risk of rising unemployment pushing the US into a recession spurred the Fed to begin its easing cycle with a large 50bps rate cut.

We think the Fed will now follow up its September move by reducing its fed funds rate further by 25bps at each of its next four meetings to March.

The fed funds rate would fall to 3.75-4.00% by then, providing further support to financial markets and helping the US economy achieve a soft landing.

We also see other central banks continuing to cut interest rates as inflation eases. The European Central Bank (ECB) made its second rate cut of the year in September, lowering its deposit rate by 25bps to 3.50%, and is likely to ease interest rates again in December.

The Bank of England (BOE) began cutting interest rates by 25bps in August from 5.25% and is set to make another 25bps reduction to 4.75% in November.

In addition, the People’s Bank of China (PBOC) surprised by reducing its 7-day reserve repo rate from 1.70% to 1.50% as part of a broader stimulus package to support growth, real estate and equity markets.

We think investors should maintain a modestly Overweight stance towards risk assets given the tide of monetary easing. But we recognise risks remain this year, including geopolitical tensions and the US elections. If the new US president follows more inflationary policies, then the Fed may be forced to stop cutting interest rates next year, to the detriment of financial markets.

US – Fed starts easing with a large 50bps rate cut

The Fed surprised by starting its easing cycle with a 50bps cut in its fed funds rate from 5.25-5.50% to 4.75-5.00%, rather than by 25bps as widely expected by investors.

Chairman Jerome Powell justified the decision by arguing the Fed wanted to ensure US employment stayed firm after weakening recently: “the labour market is actually in solid condition, and our intention with our policy move today is to keep it there.”

The unemployment rate has increased from five-decade lows of 3.4% last year to 4.2% now after the Fed aggressively raised interest rates in 2022 and 2023 to curb inflation. The labour market slowdown over the course of this year has made officials wary that a further increase in unemployment now could cause the economy to tip into a recession.

The Fed Chair also said the 50bps rate cut reflected officials’ “confidence that inflation is coming down toward 2% on a sustainable basis.”

Core inflation excluding volatile food and energy prices, has fallen sharply from its four-decade highs above 6% in 2022 when the US fully reopened from the pandemic. Thus, with officials more worried about unemployment and less concerned by inflation, the Fed chose to start off rate cuts with a larger than expected 50bps reduction.

The Fed, however, did not signal its intention to keep cutting rates by 50bps in the future. Its forecasts imply 25bps rate cuts at November’s and December’s meetings, and a further four 25bps reductions next year.

We also see the Fed slowing down the pace of its rate cuts as the economy seems unlikely to suffer a recession this year. We thus expect the central bank will cut interest rates by 25bps at its next four meetings to March as inflation keeps falling, rather than repeating September’s large 50bps move.

Over the next few months, further Fed rate cuts should thus keep supporting risk assets. But beyond March, additional rate cuts will depend on the new US president. If more inflationary policies are passed, then the Fed may be forced to stop cutting rates after March, to the detriment of financial markets.

China – Major stimulus from the PBOC

Following weak data that showed China’s recovery from the pandemic continues to slow as consumers stay cautious and as property markets stays fragile, we downgraded our economic growth forecasts for this year to 4.7% from 5% previously. However, the PBOC has since surprised by announcing several steps to support growth.

First, the PBOC cut key interest rates. Its 7-day reverse repo rate was reduced by 20bps to 1.50% and the 1Y Medium-term Lending Facility (MLF) rate was lowered by 30bps to 2.00%. Second, banks’ reserve requirement ratios (RRR) were reduced by 50bps to 9.50% to free up an estimated CNY1t of liquidity. Third, to support the property market, interest rates on current mortgages were cut by 50bps and downpayment ratios for second property purchases were reduced from 25% to 15%. Fourth, to support equities, the PBOC will set up a new CNY500b facility to allow insurers, funds and brokers to borrow directly from the central bank to invest in shares. The PBOC will also set up a re-financing facility for banks to aid firms’ share buybacks.

The monetary action by the PBOC is striking and shows officials still aim to hit this year’s GDP target of “around 5%” growth. We expect further fiscal easing will be announced to boost demand and curb the risk of deflation. Investors are thus likely to keep reacting positively as officials show determination to support growth this year.

Europe – Further rate cuts needed to support

In September, the ECB, as widely expected, reduced its deposit rate by 25bps for the second time this year from 3.75% to 3.50% and signalled further cuts were likely.

We think the ECB will keep reducing interest rates each quarter by 25bps as inflation continues to fall with the next cut likely in December. But next year, the ECB may speed up its rate cuts if Eurozone growth stagnates rather than rebounds. The central bank may thus start reducing interest rates at each meeting from January onwards.

In contrast, the BOE seems more wary of inflation. Last month, it kept its Bank Rate at 5.00% after making its first cut in four years in August. Officials still intend to lower interest rates, but warned future cuts may only be gradual. We expect the BOE will cut again by 25bps in November to 4.75% as UK inflation at 2.2% is near its 2% target. But we expect the BOE will only keep easing by 25bps each quarter in 2025 as core inflation is higher at 3.6%. The BOE’s gradual approach should thus benefit the Pound.

Japan – Further interest rate rises are likely

In September, the Bank of Japan (BOJ) left its overnight call rate unchanged at 0.25% after making its second hike of the year in July. But officials signalled interest rates are likely to rise further as inflation is anticipated to keep firming. Governor Ueda said the BOJ would raise rates again if its outlook was achieved. We think this is likely as Japan’s core inflation rate in August picked up to 2.1% above the BOJ’s 2% target.

As with the Pound, we expect the Yen is set to benefit as we think the BOJ is likely to increase interest rates again in December to 0.50% to curb inflation. We thus continue to see the currency rebounding against the US Dollar to 140 over the next year, helped by the Fed also cutting interest rates further in 2024 and 2025.