Breaking from the herd: What the differing pace of central bank easing could mean for fixed income
October 11, 2024
October 11, 2024
Breaking from the herd: What the differing pace of central bank easing could mean for fixed income |
If a social anthropologist were to study central bankers, she would probably conclude they are social beings who like to adhere to the norms and fashions set by the central banking community. They read the same research papers, attend each other’s conferences and do secondments to each other’s offices. Many have also attended the same universities. Not surprisingly, they often think similarly and implement similar policies along similar timelines.
But this herd behavior is not necessarily due to peer pressure, as central banks often face related challenges at the same time, and a co-ordinated response can also work better for everyone. In recent years, the Covid pandemic led to a huge shock to the supply side of the global economy, which caused all central banks to ease policy together. By 2022, the inflationary consequences of the pandemic led them to raise rates equally aggressively, once again in unison (with the notable exception of the Bank of Japan).
Now, as we approach the end of 2024, the fashion is in favor of cutting rates. However, the expected pace and extent of this easing varies considerably from bank to bank. The U.S. Federal Reserve (the Fed), for example, started cutting later than other central banks in September—after the European Central Bank (ECB), Bank of England (BoE), Bank of Canada and Reserve Bank of New Zealand (RBNZ)—but then cut by 50 basis points (bps), more than the other central banks and more than most economists originally forecast. The increased dovishness means the market is now pricing a total of nearly 250bps of rate cuts by the end of 2025 from the Fed, 150bps more than was priced six months’ ago.
While some central banks are expected to ease by a similar amount (i.e., the Bank of Canada, RBNZ and Sweden’s Riksbank), many are priced to do significantly less: Only around 100bps from the Reserve Bank of Australia and Swiss National Bank, 175bps from the BoE and Norges Bank, and the Bank of Japan is priced to raise rates 50bps. In comparison to six months’ ago, when nearly all banks were priced to cut between 50 and 100bps, the market is now expecting a far wider range of central bank policy outcomes in addition to more aggressive easing.
In most cases there are good, fundamental reasons for the divergence in expectations. U.S. inflation is slowing in an orderly manner and the labor market data have turned clearly weaker, meaning the Fed is now more focused on the growth side of its mandate than curbing inflation. By contrast, European core inflation remains stubbornly high, restricting the pace at which the BoE and ECB can ease policy, even if growth looks worse. The RBA is also dealing with still elevated Australian inflation and, having not raised rates by as much in this cycle, needs to cut by less going forward. By contrast, the RBNZ raised rates as high as the Fed hiked (to 5.5%) and now must deal with a very weak economy, so is expected to ease more aggressively. And the BoJ remains out of sync with the others: Inflation increased later in Japan than in other economies, and only back to the central bank’s target after decades of deflation; so the challenge is to normalize policy while keeping inflation higher than it has been.
The variation provides opportunities and challenges to our fixed income portfolios, in particular cross-market rate differentials and currencies. We feel that the easing being priced for the Fed is demanding, especially if the U.S. economy remains as robust as we expect it to. We see better value in other government bond markets (New Zealand and Canada) than U.S. Treasuries, where growth is worse or the central bank more dovish. Lower U.S. interest rates also support a weaker U.S. dollar, which creates an environment that has historically been supportive for emerging markets. We also expect to see more currency strength from central banks which lag in cutting interest rates.