Let there be cuts!

Perhaps the most important development of the past few days has been major central banks finally embarking on the rate cuts cycle after starting to increase them about two years ago. Bank of Canada delivered its first cut on 5th June 2024 by reducing the policy rate to +4.75% from +5.00% and European Central Bank followed the next day on 6th June 2024 with reduction in its deposit policy rate to +3.75% from +4.00%. Swiss National Bank and Riksbank (Central Bank of Sweden) had already delivered first policy rate cuts in March 2024. After a long wait of more than two years, when Bank of Canada started increasing interest rates in the March of 2022, investors can finally look forward to policy easing and thus potentially lesser headwinds for capital markets.

Canadian economy is relatively more leveraged and hence more sensitive to the interest rates as compared to the United States. The expectations of the rate cut in the June meeting had built up further after the first quarter GDP growth was registered at +1.7%, much below the forecast of +2.8%. The unemployment in Canada has been inching up and has reached +6.2% for May (reported in June) (See figure 1). The governor of Bank of Canada, Tiff Macklem, stated that it is reasonable to expect further cuts to policy rates provided inflation continues to ease and the confidence that inflation is headed sustainably to the target 2% continues to increase. However, he also cautioned that pace is likely to be slower.

Figure 1: Canada Unemployment rate, %

Source: Statistics Canada, Bloomberg

The message from the authorities of the United States Federal reserve remains unchanged so far where they seek more evidence that inflation is headed towards the goal of 2%. Mixed economic data with somewhat higher-than-expected headline inflation prints during the past few months has forced the Fed to adopt a relatively hawkish tone as compared to other central banks, in our opinion. Divergent policies will have implications on the currency markets and thus we believe either the Federal Reserve will follow the lead of other central banks soon or the other central banks will have to delay the next rate cut, should the data in the United States forces the Federal Reserve’s hand to wait for longer.

We note that the ISM (Institute of Supply Management) Manufacturing PMI (Purchasing Managers Index) has been indicating contraction in the activity in the US and the ISM Services PMI has been indicating an expansion (See figure 2). An index level above 50 indicates expansion and below 50 indicates contraction. Given that services sector constitutes majority (~78%) of the United States GDP, it is fair to say that on a balance the US economy has been strong. The unemployment rate in the United States too has been below 4% though job openings have been on a decline and initial jobless claims increasing, indicating some deterioration.

Figure 2: ISM Manufacturing and Services PMIs

Source: Bloomberg

Overall, we think that the advent of policy rate cuts by global central banks is a positive development for the markets, however, the mixed economic data in the United States still raises a question mark on the timing of first rate cut by the US Federal Reserve. Year-to-date, the fixed income markets have wavered as expectations of the first rate cut from the Federal Reserve fluctuated from as early as the June meeting to as late as December meeting. Looking ahead, incremental policy clarity from the world’s central banks could set the stage for reduced volatility in the bond markets, in our view.