Back in June I talked about how for all the talk of monetary policy divergence this year, the real story is about reconvergence. 

“For all the talk about divergence between central bank policymaking – particularly the ECB and Fed – the current price action is one of reconvergence, with EZ inflation, yields and the Euro starting to move up and Treasury yields, USD and PCE inflation falling – US/German yield spreads have narrowed a lot over recent weeks.” 

Then, US-German 10yr spreads had declined to 180bps from 220bps in June. Today the spread is closer to 150bps.  

But for all that, we have seen a bit of divergence this week in terms of global FX. The interesting thing for markets is the difference between realized divergence (ie what we saw this week) and expected divergence, which is increasingly less on show. 

Mumbo jumbo 

The Fed’s 50bps cut sent FX markets into turmoil, but it all seems to be settling down now. There were also some big swings in other asset classes, including stocks and gold which were chased into Friday’s session in the wake of the monetary policy decisions by the Bank of England and Bank of Japan. 

The Fed cut by 50bps, which was the jumbo cut the market had been looking for. Policymakers appeared to be leaning more into the jobs side of the dual mandate, which suggests concern that they are seeing signs the unemployment rate could accelerate higher in the coming months…the implied rate for December dropped by 15bps. 

And yet…the dot plot showed just another 50bps of cuts this year. The market initially felt 50bps today means the Fed is locked into doing 50bps again and again as the jobs market deteriorates. Powell wanted to disabuse the market of this assumption. He said: “I do not think that anyone should look at this and say, ‘Oh, this is the new pace.’”  

Powell managed to say that the reason for a big cut is to lock in the gains rather than it being a sign of things to come. “The US economy is in a good place and our decision today is designed to keep it there… We do not think we are behind [in cutting rates], but you can take this as a sign of our commitment to not get behind,” he said. 

I think it was more of a catch-up cut – tacit admission they’d maybe got behind things a bit but no alarm. And it admits that the Fed funds rate was a little too restrictive, even if financial conditions are ok, the market is at an all-time high and a path of gradual rate cuts baked into market assumptions meant that it could just have easily gone for 25bps. To illustrate the amount of catchup the Fed felt it needed to do, before the decision the 2-year Treasury rate was 3.56%, while the Fed funds rate was 5.33%, resulting in a spread of -1.77 percentage points, which was the widest it’s been since 1988.  

Financial conditions are not overly restrictive – Chicago Fed index at loosest since Jan 2022. 

The Summary of Economic Projections (SEP) contained some changes from June. Inflation expectations trimmed to 2.3% from 2.6% in June, and down to 2.1% vs 2.3% in 2025. Unemployment revised up to 4.4% from 4.0% this year and up to 4.4% from 4.2% in 2025. And most interesting of all the Fed funds rate next year is seen at 3.4%, down from 4.1% forecast in June, with the long-run rate seen at 2.9%, down from 3.1% from June. The median dot plot signal an extra 50bps of cuts this year, followed by 100bps next year, and 50bps in 2026, with a terminal rate projected at 3.0%. 

Divergent, for now 

Yesterday the Bank of England was unchanged. The UK now has higher rates for an economy that is growing at a speed about one third that of the US and inflation is lower…go figure. The Bank of Japan was also unchanged overnight. This week the Fed went large, the BOE and Norges Bank stood still, South Africa’s Reserve Bank cut for the first time in years and Brazil hiked: monetary policy divergence is back. Combined with the Fed doing the jumbo cut, it’s a) good news for emerging markets and b) good news for FX volatility, if that’s your thing, and c) great news for gold. 

To illustrate the increase in FX volatility, the good old Guppy went bananas this week. 

The BoJ stood still and said there is no need to hurry rate hikes – given the Fed’s jumbo move another kick in the guts to the low vol carry would have been unnecessary…but a key inflation gauge has accelerated for a fourth straight month so they will have to hike at some point. The South African central bank was able to kick off its easing cycle, largely thanks to the Fed I suppose but also because inflation has cooled a lot. August’s 4.4% print was the first time it dipped below the midpoint of the SARB’s 3-6% target range in more than three years. Brazil is going the other direction and it seems the hike was about restoring credibility (note, I am not a watcher of LatAm markets). The Norges Bank is seen cutting soon, the Bank of England even sooner.  

Gold rallied to fresh all-time highs this morning – rates down, economy purring along nicely – hedge against reacceleration in inflation is clearly a factor here beyond simple weak dollar/lower real yields mechanics…no stopping the 4D trade and I can’t see why we don’t notch another big level in the next year, though we are ripe for a retracement at this stage with the extension higher maybe needing some consolidation. The 10yr TIPS yield is down about 100bps in the last year, but there is a lot more to gold’s rally than this, as have discussed many times. 

And Bitcoin has caught some of the prevailing breeze to test the 200-day SMA. 

Risk  

The rate cut was – is – great for risk assets, at least in the near term. JPM: “Over the past 40 years, the Fed has cut rates 12 times with the S&P 500 within 1% of an all-time highs. The market was higher a year later all 12 times with an average return of around 15%.” 

But…there was no real agreement on where the long-term rate should be – the spread among FOMC policymakers was 175bps. Bowman dissented on the vote – the first for a governor since 2005. And inflation. Watch inflation. We could see the euphoria end abruptly if the market starts to sniff out higher inflation because that would keep the Fed tighter than is currently being priced…watch those inflation gauges. As this reaccelerates, we will see tightening in fed funds futures and the Fed might have to rethink things. This could be a weight on risk assets. Resurgent inflation could kill the bull market, but it will likely keep volatility up. 

Neil Wilson

Chief Market Analyst at Finalto

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