Key points

• Powell delivered a dovish pivot, as the Fed cut rates by 50bps at this week’s FOMC meeting.
• There appears to be an equal chance of the Fed delivering a 25 or 50bps rate cut at its next meeting, in November.
• The Bank of England kept rates on hold this week. The UK economy is growing at a modest pace, housing market and construction activity is picking up, and employment remains relatively robust.
• Looking ahead, market focus moves back onto data. Powell was explicit with respect to the data dependency of the Fed, and readings around the labour market will take an elevated priority.
  The decision by the Federal Reserve to cut rates by 50bps at this week’s FOMC meeting largely vindicated the recent rally in yields seen over the past month, with Powell delivering a dovish pivot.

Nonetheless, the Fed Chair was at pains to underline that the economy remains healthy, assessing risks to the outlook as broadly balanced. He also noted that the 50bps cut is not meant to signal the new pace, guiding listeners to the dot plot forecasts, which continue to embed less monetary easing than has been priced into market expectations.

Consequently, although the outcome of the Fed meeting looked like a close call between 25bps or 50bps on the day of the meeting, yields struggled to post further gains on the day.

As we assess the FOMC, we are struck that this Fed appears eager to try to run growth as fast as it can, without inflation moving too high. Current quarter projections of GDP are running close to 3% and, although a higher unemployment rate has been cited as a source of weakness, it seems clear that this reflects an increase in labour supply. If recession risk appeared unlikely to us in the near term, it seems that the Fed is determined to extinguish any risk of this whatsoever.

Meanwhile, if an easing of financial conditions leads to an economic reacceleration, then it might strike us that the recent downtrend in inflation could start to reverse. From this point of view, there is equally a chance that the Fed delivers 0,25 or 50bps at its next meeting in November, depending on economic data and market behaviour in the interim.

Moreover, we might infer that a more assertive Fed, seeking to maximise growth, may point to outcomes on medium-term inflation and neutral interest rates, which may be a bit higher than might otherwise be the case.

Looking ahead to the US election, we would also infer that risks are skewed towards ongoing fiscal easing. Were Trump to win the race for the White House, then we would see tariffs and moves on inflation also adding to inflationary pressure.

Consequently, when looking at Treasury yields around 3.5% on 2 to 10-year bonds, we think there may be limited scope for these to rally by much, unless a material economic downturn is to manifest. Ironically, therefore, a more dovish Fed in the very short term might end up limiting the scope for rate cuts further ahead.

Additionally, we continue to think that the 2-30 yield curve should steepen and longer dated bonds will need to price a higher-term premium. In part, this is a function of rising fiscal risks and the need for additional supply.

Furthermore, this is also a function that longer-term inflation outcomes may be less certain. From this point of view, we maintain a curve steepening bias and also have added positions in inflation-linked bonds, expressing a view towards somewhat higher breakeven rates.

Looking at equities, we would note that what matters most to earnings is robust nominal economic growth. In adopting a stance whereby the Fed is keen to push this as high as it can without too much inflation, there is a sense that the Fed has your back as a stock investor. Past 50bps Fed cuts have occurred, following pronounced equity market weakness. The fact that the Fed is happy to deliver 50bps when the equity market is close to record highs could easily be a sign to invigorate bulls further, as long as economic data does not disappoint. In this way risk assets will look to rally on signs of any good economic news.

Turning attention across the Atlantic, the Bank of England kept rates on hold at its Monetary Policy Committee meeting this week. Core CPI rose to 3.6% last month and although the headline rate, at 2.2%, is close to the Bank’s target, service price inflation remains worrisome at 5.6%.

Over the next few months, headline CPI is expected to rise and, in this context, we think that it will remain difficult for the BoE to deliver much, or any, monetary easing. The UK economy is growing at a modest pace, housing market and construction activity is picking up, and employment remains relatively robust.

Consequently, it might appear that the economy is coping with elevated interest rates. Yet with a tough Budget ahead, the growth trajectory may remain disappointing in absolute terms.

We continue to have a downbeat assessment of EU economic prospects. However, travels in Europe this past week have reaffirmed how countries in southern Europe continue to outperform their northern peers. In Spain, the debt-to-GDP ratio was revised lower for 2024, on the back of higher growth projections, and rating agencies continue to see migration of Spanish ratings in a positive direction. In Portugal, the economy seems to be booming, with Lisbon literally buzzing.

Yet prospects in Germany, France and much of northern Europe remain more sombre. Noting that it was a crisis 10 years ago that saw substantial reform in much of Europe’s south, one wonders if a clearer crisis will be needed in the north in order to create an inflection point. A sense of entitlement on the part of many and a sense of ongoing comfort amongst the elite remain obstacles to taking more assertive action, though we sense that political pressure in the region is only likely to continue to build.

In Japan, the BoJ also met this week. Interest rates were left unchanged, as expected. We think that moves in Japanese policy are likely to come around quarterly BoJ meetings. However, the next of these meetings in October may be overshadowed by the LDP Leadership election, which will determine the next Prime Minister, and it is quite possible this will lead to elections shortly after.

In this case, the BoJ may wait to raise rates again until January. However, the economy continues to evolve as hoped for and we remain confident in the direction of travel – even if timing is less certain. We continue to see long dated JGB yields as much too low in the 10-year part of the curve and likely to rise, as JGB purchases by the BoJ decline and as monetary policy tightens.

We also expect the yen to appreciate further in the medium term. However, on a shorter-term view, if the US economy remains as robust as we expect and US rates decline by less than is currently discounted, then the shorter-term trend in the rate versus the dollar may be back above the 145 level.

Turning to risk assets, this week's Fed action has helped credit spreads to rally, with stocks moving higher and volatility declining. Although spreads are compressed, we sense that many investors are under-positioned in credit, having formed a more cautious assessment of the economic outlook. If data remain firm, we expect those investors to get squeezed back into the market.

We have also heard that some US banks had sought to lighten up their inventory in order to shrink balance sheets, as they have wanted to attain Fed approval for share buybacks and dividend payments of late. This de-risking coincided with elevated supply early in the month and was a factor pushing spreads wider. With these approvals now granted, a rebuilding of positions also adds to the bid for corporate credit.

We also see the Fed actions in a favourable light from an EM perspective. Higher growth is generically bullish for EM and lower US cash rates are similarly supportive. We continue to see value in rate curves in EM local currency, which has felt like a bit of a forgotten asset class in 2024 and could now be poised to perform. We also see EM credit able to rally in line with IG and HY assets.

Looking ahead

With the Fed now out of the way, market focus will be back onto the data. Powell was explicit with respect to the data dependency of the Fed at this week's meeting and clearly readings around the labour market will take an elevated priority within this. Looking at the calendar, the next couple of weeks are relatively quiet on the data front, with the bulk of relevant releases front-loaded in the first half of the month.

That said, we look for signs that an easing of financial conditions is helping to stimulate sentiment and economic activity in interest rate sensitive sectors, such as construction. Instead of an economic slowing, we might even witness a mini boom and it is not lost on us that Powell may have quietly wanted to juice the economy as much as he can, in the short term, with November's election in mind.

The US elections will be a major risk event coming over the horizon and recent momentum has continued to edge towards Harris. However, much can and will happen in this race in the weeks to come, and we note that Democratic candidates have tended to bleed support during the last two months of both recent US elections.

In the Middle East, scenes of exploding pagers and walkie-talkies in Lebanon seem almost reminiscent of a plot line from James Bond or Mission Impossible. We suspect that these alleged attempts by Israel to decapitate Hezbollah's leadership through acts of espionage seem only likely to provoke tensions, akin to kicking a wasp's nest.

That said, we might suspect that this move, if true, was part of a strategy by Netanyahu to broaden the conflict, sensing Iran has limited appetite for a larger conflagration and knowing there is little the US will say or do to restrain Israel in the run-up to November's vote. Indeed, an escalation of Middle East tensions may also help Trump, which would similarly seem to benefit Netanyahu and his kin.

It is a reminder that we live in volatile times, and we need to be aware of the scope for geopolitics to act as a catalyst for commodity prices or supply chain disruptions. Meanwhile, at a time when it has become fashionable for employers to roll out company-owned devices to their employees, maybe I shouldn’t grumble about being in receipt of an iPhone which I am assured is pretty much locked down and ‘cold’.