By Dorval AM

The first rate cut, of 50 basis points, announced by Jerome Powell on September 18 materializes the change in the Federal Reserve’s rhetoric since the end of last year. It comes at a time when the US economy seems more resilient than some had feared.
Alternately warmed and then cooled by Jerome Powell’s successive speeches since the end of last year, investors around the world finally have something concrete to sink their teeth into. US money-market rates – one of the most important variables in global finance – began their descent with a first rate cut of 50 basis points on September 18, from 5.25-5%-5,50% to 4.75-5%-5,25%25. This rate cut reflects a change in the risks perceived by the Federal Reserve: its inflation target of 2% appears to have almost been reached, while the slight rise in the unemployment rate observed in recent months threatens its objective of full employment (graph 1).

By cutting rates by 50 basis points instead of 25, Jerome Powell intends to maximize the effects of his insurance policy. It is now clear that if the next employment and unemployment figures deteriorate again, the rate cut will continue at a high pace. If unemployment stabilizes, the rate cut will be more gradual. The central scenario currently underpinning both market expectations and those of Fed members is that of short-term interest rates landing on levels close to 3% by the middle of next year.
The trajectory and terminal level of the rate-cutting process are, however, far from predetermined. After several months of disappointment on the economic front, the latest statistics point to a still solid US economy (+3% growth in Q3, according to the Atlanta Fed’s “GDP Now” flash estimate), and economic surprise indices are picking up (graph 2). Consumer confidence picked up in September, retail sales rose and industrial production rebounded in August, as did building permits. As for weekly jobless claims, they have recently started to fall again. So it’s not certain that the next job report, due for release on October 4, will point to a further slowdown in employment – or even the opposite.

For the equity market, this context of a solid US economy and falling money market rates is obviously favourable. Since the summer, however, competition has been tight between the equity market and the long-term bond market (graph 3), the latter being supported by the momentum of falling money market rates and the potential for gains in the event of a sharp economic slowdown. The competition remains open, but it seems fairly unlikely to us that government bonds can continue to perform as well as they have over the last three months, now that they are incorporating Fed rates at 3% next year, the US economy remains solid, and the Fed’s action is protecting global growth expectations. We therefore continue to overweight equities in our allocations (we slightly raised our exposure rates after the Fed’s decision), and at this stage maintain a virtually zero bond duration.