The US Federal Reserve’s recent interest rate cut, although anticipated, is set to prolong the three-year equity market rally. The cut, reducing rates by 0.25 per cent to between 4 per cent and 4.25 per cent, adds fuel to an economy already buoyed by artificial intelligence investment and previous tax cuts. This decision comes despite inflation exceeding the Fed’s 2 per cent target for the past four years, shares trading at record highs, and corporate bond spreads sitting at record lows. Vantage Point Asset Management is a macro fund. Mercer is a global financial services giant.
Despite the potential for continued gains, some analysts warn of underlying risks. One concern is whether the Fed’s assessment of a cooling labour market is accurate, potentially leading to a more significant economic downturn than currently anticipated. While the Fed forecasts two more cuts this year and one next year, markets expect even lower rates by 2026. However, these expectations may not fully account for the economic deterioration that typically accompanies such rate cuts.
Another risk involves the potential for the rate cuts to exacerbate inflation, undoing the Fed’s previous efforts. Some economists argue that the cuts are akin to adding ‘gasoline on the fire’, potentially fuelling speculative activity in the stock market. The Fed will be closely monitoring inflation, particularly through the producer price index, to gauge the impact of its monetary policy decisions.
A final, more extreme risk centres on the Fed’s independence. If rate cuts lead to a resurgence of inflation, a crisis of confidence in the bond market could emerge. This, combined with high government debt levels and loose monetary policy, could send long-term bond yields soaring, triggering a debt crisis. The ability of central banks to collaborate and prevent such crises, as they have in the past, is also in question, particularly in a more protectionist global environment.
