Mission Impossible?
The first quarter of 2024 witnessed fixed income investors recalibrating their expectations of about six to seven policy rate cuts in the United States to about three at the end of the quarter. While the adjustment was a disappointment for fixed income investors, who have been waiting for a consistent and positive contribution from the asset class for some time, the equity markets continued to cheer the prospects of finally turning the corner on policy rates and improving economic growth. The North American equity markets saw consecutive gains for the first three months of the year. The month of March was also in green, however, leading the charge were the cyclical Energy sector and Materials sector as against the Information Technology sector and Communications Services sector during the first two months.
Commodity prices have increased (See Figure 1), driven by higher demand, indicating an improving global economic outlook. In the latest readings, the US Institute of Supply Management’s Manufacturing Purchasing Managers’ Index (50.3 for March 2024) and China Manufacturing Purchasing Managers’ Index (50.8 for March 2024) have both jumped above 50, corroborating the narrative that manufacturing activity is on the mend (See Figure 2). A reading above 50 indicates expanding activity and a reading below 50 indicates contracting activity. China is the world’s largest consumer of commodities and improving manufacturing in China typically has had a disproportionate impact on commodities prices. However, for the markets fixated on the policy rates trajectory, any data point that reads through as policy rate cuts might get delayed, gets discounted as bad news. Higher commodity prices also read through as return of goods inflation and thus potential delay of policy rate cuts, which has caused some jitters in the markets. The recent jump in the crude oil prices driven by: a) the decision by OPEC+ (Organization of Petroleum Exporting Countries) to extend the production cuts for the first half of 2024; b) escalation of geopolitical tensions in the middle east; and c) improving demand given the global economic acceleration, has increased the risk that headline inflation numbers might disappoint in the near-term.
Figure 1: Commodity prices have started to move higher.
Commodity Research Bureau BLS/US Spot All Commodities (April 2021 to April 2024)
Source: Bloomberg
Figure 2: Manufacturing activity is back in expansionary territory.
US ISM Manufacturing PMI and China Manufacturing PMI (March 2020 to March 2024)
Source: Bloomberg
The economic data has been more supportive to the case of policy rate cuts in Canada where inflation declined to +2.8% in February (reported in March) from +2.9% in January (reported in February) and unemployment rate also advanced to +5.8% in February (reported in March) and again to +6.10% in March (reported in April) from +5.70% in January (reported in February). The data in the US has not been as supportive for the case of policy rate cuts. The headline inflation reaccelerated to +3.2% in February (reported in March) from +3.1% in January (reported in February) and unemployment rate advanced to +3.9% in February (reported in March) from +3.7% in January (reported in February) but declined again to +3.8% in March (reported in April). The strength in the US economic data has led the fixed income investors to reduce their expectations of rate cuts as evident from the CME Group’s Fed Funds Futures data. The probability of no rate cuts during the June meeting advanced from 0% as of 31 January 2024 to ~50.8% as of 5 April 2024 (see figure 3).
Figure 3: Expectations of no rate cuts during the June meeting have increased.
Target rate probabilities for June Fed meeting (31 Jan 2024 vs 5 April 2024)
Source: The CME Group
Sticky inflation could necessitate higher interest rates and for longer, which in turn will increase the risk of damage to the economy. Layering on the fact that the historical precedents of central banks’ ability to control inflation by hiking interest rates without triggering a recession are rare, seems to suggest that this mission looks impossible. However, we think the jury is still out on this and maintain our constructive outlook towards the global economy and risk assets. Our optimism is underpinned by our belief that central banks in the current era have learnt from the mistakes committed in the past and stand a better chance of reacting and fending off the adverse impact of any missteps. The timely resolution of regional banks crisis last March is a case in point.
Furthermore, while the headline data does suggest labor market in the United States is on a strong footing, several datapoints suggest incremental weakening under the hood. This bolsters our belief that the strength in the labor market is just enough to suggest a growing economy but falls short of indicating an economy running hot and therefore inflationary. The ratio of total job openings to people looking for full time employment has been on a decline and the ‘US quits rate’, a measure of voluntary job separations initiated by the employee, has also been on a decline (see figure 4). Overall, we think the balance of economic data is consistent with the view of the Federal Reserve Chair, Jerome Powell, who recently stated that the latest data, despite somewhat stronger than expected, is in line with their expectations and does not derail the case of beginning to lower policy rates at some point during this year.
Figure 4: Labor market is moving to better balance.
Ratio of US job openings to unemployed looking for full time employment and the US quits rate (February 2018 to February 2024)
Source: Bloomberg
