News & Insights

Central Banks Easing in Concert J

The developed world’s central banks are back in the spotlight. The Bank of England is the latest to begin an easing cycle, joining the monetary authorities of Switzerland, New Zealand, Canada, and the Eurozone. The Federal Reserve declined to cut interest rates in its last meeting, but with Chairman Jerome Powell’s clear indication at Jackson Hole, cutting is practically a certainty. Clearer signs of disinflation in tandem with a weakening employment picture across developed economies are pushing central banks into a synchronized easing cycle. Policy makers across the world appear to be champing at the bit for the opportunity to cut rates as the risk of policy errors increases. This presents the Fed and other central banks with an opportunity to pivot to the employment side of their mandate, forestalling a significant rise in unemployment as the economy slows.

The president of the European Central Bank, Christine Lagarde, is facing a different picture. The European Union has a mixed job market across the bloc, with France and Spain seeing a falling unemployment rate, while Italy’s and Germany’s are rising. Euro area unemployment rose modestly, 0.1 percentage point to 6.5%, off the cycle low of 6.4%. The dramatic fall in inflation in the Eurozone frees policy makers to lean toward easier policy, with the important support of Germany, which is uncharacteristically beset by one of the weakest job markets in the bloc.

Australia has been the laggard in adjusting its policy rate. Australia continues to deal with inflation that has been stickier than in other countries. Inflation was at 3.8% at the last policy meeting. It has since fallen to 3.5%, but that was still above expectations of 3.4%. The inflation surprise has thrown a wet blanket on expectations for a rate cut in September and pushed them out to December.

China has also been easing in the face of a faltering economy, though the actions have been far short of game changing. More aggressive easing would risk a further weakening of the yuan, which Chinese authorities have been trying to defend. The recent decline in the dollar against a broad basket of currencies may allow the Peoples’ Bank of China to pursue a more stimulative policy.

The globe appears to be on track for significantly lower rates, which should bolster both growth and risk assets. As the year plays out, a global version of the adage “don’t fight the Fed” may prove to be wise counsel.

Expectations for Central Banks to Cut Rates Have Picked Up Over the Last Few Months

Source: Bloomberg

Developed World CPI % YoY

Source: Bloomberg

Japan: Unwinding 40 Years of Easy Money

The Bank of Japan has started a campaign to raise rates at the beginning of a worldwide easing cycle. Citing yen weakness and persistent inflation risks, the central bank has allowed rates to rise over the past year, recently setting policy rates at 0.25%, an increase of 15 basis points. This shift last month shook global capital markets, prompting an abrupt unwind of a popular carry trade, created by investors borrowing in yen and investing the proceeds in higher- yielding assets.

The BoJ finds itself in a conundrum, with policy makers attributing a recent contraction in GDP to a decline in consumption because of a weakening yen, the result of a protracted period of ever lower interest rates in pursuit of economic stimulus that has spanned almost 40 years. The BoJ has to choose between hiking rates to defend the currency (containing import prices) or lowering rates more to stimulate additional borrowing and preserve GDP. Achieving one of these outcomes will be to the exclusion of the other.

The surge of inflation that affected the developed world over the past three years raised the cost of goods and services in Japan, catching the economy off guard with deeply negative interest rates, as the waves of higher prices hit Japan’s shores. Policy makers were paralyzed as the value of the yen depreciated 36% in the period from January 2021 through July of this year. A recent change in leadership of the monetary overlords provided cover for a change in policy, albeit enacted at a snail’s pace, as their “yield curve controlled” 10-year government bond rose from 0.3 basis points in January 2021 to 1.07% in July. In the aftermath of the recent one-day correction in the Nikkei, the rate has retreated, settling recently at 0.90%, with the yen rising more than 10% from its low in early July.

Though the central bank is left with no easy choices, it likely made the correct one in this latest policy statement, with second-quarter GDP growth coming in the following week above expectations at 0.8%. However, the recent volatility in Japanese markets caused central bank officials, including Deputy Governor Shinichi Uchida, to pour cold water on any further tightening this year.

With rate differentials in Japan narrowing in tandem with the yen appreciation, and many of the high-flying AI names experiencing more moderate returns (a chart below illustrates that the yen borrowing translated into increased investment in the recently hot stock names), much of the incentive to restore the “carry trade” appears to be gone. Analysts in the FX space agree this trade has largely unwound and is unlikely to be restored, taking one risk for global equities off the table.

Yen Carry Trade was Fueling AI Stock Rally

Source: BCA Research’s Counterpoint

Bank of Japan Interest Rates

Source: Bloomberg

Rally for Small Caps

After several years trailing large-cap returns, small caps may be having their moment in the sun. Small companies depend more heavily on the domestic economy for growth and banks for access to financing. This asset class is highly sensitive to the short end of the yield curve, so imminent rate cuts to the fed funds should create a tailwind in 2025 for small caps. They stand to benefit disproportionally from a pickup in the economy and falling interest expense, improving profitability for this very important segment of the economy.

Small-cap earnings suffered as interest rates soared, while large cap stocks have been largely insulated as they can access the public markets directly, while capitalizing on short term interest income for a positive contribution to profits. With over 90% of the constituents reporting for the second quarter, the Russell 2000 has positive earnings growth for the first time in five quarters, surprising to the upside by 7.9% on average. This earnings momentum should be helped by falling rates as inflation continues to abate. With the recent positive GDP print, and a decelerating labor market giving the Fed cover to cut rates over the next year, small caps’ greatest woes may be behind them.

Russell 2000 Index, S&P 500 Index, NASDAQ Composite Index 3-month % Changes

Source: Bloomberg

Small Cap vs Large Cap Forward EPS

Source: Bloomberg

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