US rate cuts are priced in: any further upside?

US rate cuts are firmly on the agenda and apparently fully priced into the market. But is that pricing correct, and what’s the potential for further upside in equities and fixed income? This week’s Simply put uses a regression analysis to consider other correlations that could likewise move the dial for multi-asset investors.

Rates set to dip – what next?

The initial, and long awaited, Federal Reserve rate cut is imminent after the Jackson Hole meeting set September 18 for the first decrease of this cycle. The development marks the end of a long plateau for policy rates, during which rates were significantly higher than inflation. It also rounds out the Fed's official pivot back in December 2023, which at the time surprised markets.

Despite varying views in the market, US rates will indeed fall this year. The question now is: what impact will loosening have on financial markets? The reality is that markets have largely anticipated the September cut and several more by the end of the year, pricing it as a central scenario in forward curves. But is it correctly priced? This week’s edition of Simply put attempts to answer this question by examining the relationship of equities to rates using a regression analysis.
 

It's all priced in?

One key takeaway from 2022-2023 is to never underestimate the impact of interest rates. As John Cochrane pointed out¹, it was long believed that changes in equity valuations mainly reflected modifications in expected cash flows. More recently, however, it has been observed that changes in rates are a significant factor determining the performance of risky assets. All multi-asset managers painfully recognised this through 2022 cross asset shocks.

If rising long rates depress all asset prices, is the opposite effect symmetrical? Cochrane explores the delayed effects that these rate changes have on markets. A drop in short-term rates could ripple through the yield curve, pushing down long-term rates, which, in turn, could boost equity prices. Thus, could anticipated cuts in September and beyond open the door to further equity market gains?

The caveat is that financial markets are sophisticated forecasting machines: the expectation (or so-called rumour) of the Fed’s September cut influences valuations ahead of the actual rate cut, in accordance with the adage ‘buy the rumour, sell the fact.’ As such, is the rumour already sufficiently incorporated into asset prices?

Figure 1 addresses this question by analysing the performance of the MSCI World index in relation to earnings growth and changes in interest rates. The graph on the left shows how these two factors capture a large portion of the fluctuations in sliding returns. The graph on the right uses this relationship to project scenarios for earnings growth and interest rate changes, from which we calculate an expected return on a case-by-case basis. Clearly, our regression analysis indicates that the current 20% increase in the index over the next 12 months reflects the most optimistically dovish scenarios.

Simply put, the market may have already overbought the rumour, eroding any positive market effect the actual cuts may have. Still, while being mindful to steer clear from the crowd, we also see a more complex backdrop involving other factors at work.

FIG 1. MSCI World index sliding 12-month performance vs estimates based on earnings growth and interest rate variations (left) and 12-month performance by earnings and interest rate scenario (right)

Source : Bloomberg, LOIM. As at 30/08/24. The 10-year US Treasury yield is used as a proxy for interest rate scenarios. For illustrative purposes only.
 

Hope remains

Indeed, despite the market already pricing the Fed’s anticipated loosening, there is still hope, especially for balanced portfolios, in our view. Our hope stems largely from the fact that the fall in 10-year US Treasury yields from almost 5% to 3.7% could trigger a macro and a market effect, both of which might benefit investors.

• Market effect. As shown in figure 2 (left), the negative correlation between equities and rates decreases as rate levels increase. Investors paid a high price in 2022 when rates rose, but they could now benefit from rates falling. With 10-year yields still at historically high levels, any fall in rates should support risky assets more than in the low-rate era of the previous decade
• Macro effect. Figure 2 (right) illustrates the correlation between earnings growth and changes in interest rates: when interest rates rise, earnings deteriorate more with higher rates, taking into account a 12-month lag. If rates fall, they will bolster earnings, with a certain lag effect that may not have been fully anticipated by the markets

These two effects — the equity/rate correlation and the earnings/rate correlation — may therefore nuance the conclusion of figure 1. Yes, much has already been anticipated by the market, but positive elements remain that may modify this assessment. In other words, the spot picture for the rest of the year may appear to fully price current Fed expectations, but other factors, such as correlations, could still lend further support to risky assets in the near term.
 

FIG 2. Correlations between bonds and equities (left) and earnings (right) as a function of interest rate levels

Source : Bloomberg, LOIM. As at 30/08/24. For illustrative purposes only. The 10-year US Treasury yield is used as a proxy for rates.
 

What this means for All Roads

Our analysis suggests that the markets have slightly over-anticipated the effect of future rate cuts. However, overall momentum remains robust for risky assets, and has also strengthened for government bonds, a topic we previously discussed. Risk appetite, meanwhile, has normalised, although not to the same degree as in the first half of the year.

These recent signals indicate that our global exposure to risk premia should remain significant but more diversified across risky and safe assets. The proportion of fixed income exposure in the portfolio should resume more typical levels after a prolonged period of below-average exposure, consistent with inflation-linked uncertainty waning and giving way to a transition period that will require stronger diversification.
 

[1] Cochrane, John. Discount Rates (2011). Accessed 30/08/2024.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises is designed to track the progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Growth data continues converging to signal a slower growth environment. At the moment, it remains difficult to estimate the depth of this deterioration 
• Inflation risk remains higher in the data than in the consensus – this week our indicators continue pointing in that direction
• The macro data of the week call for increased dovishness from the Fed notably, consistent with the Jackson Hole meeting

World growth nowcaster: long-term (left) and recent evolution (right)
 

World inflation nowcaster: long-term (left) and recent evolution (right)
 

World monetary policy nowcaster: long-term (left) and recent evolution (right)
 

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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