Market Brief: Relief Rally Animates Markets After Fed Cut

A wave of optimism is washing across financial markets this morning after the Federal Reserve cut rates by more than expected, demonstrating a strong commitment to supporting labour markets and sustaining the US economic expansion.

Yesterday’s decision to lower benchmark borrowing rates in an unusually-large half-point increment initially triggered a rally in risk assets and a corresponding decline in the dollar, but Chair Jerome Powell generated some turbulence during the press conference as he tried to discourage bets on deep cuts at future meetings. “There’s no sense that the committee feels it’s in a rush to do this,” he said. “I do not think that anyone should look at this and say, ‘Oh, this is the new pace’”. Investors reduced odds on another 50 basis-point move between the November and December meetings, and stripped some easing out of the 2025 curve, causing currency and equity markets to reverse early gains.

But the direction of travel remained clear. Updated “dot plot” projections showed a narrow majority, ten of nineteen policymakers, thought they were likely to deliver at least two more quarter-point cuts this year, with seven expecting to ease once, and two opposing further changes. Another four cuts were pencilled in for next year, with the median estimate putting the policy rate at 3.5 percent by the end of 2025.

And messaging in the statement, summary of economic projections, and post-decision press conference was consistent with a profoundly-dovish shift in the central bank’s reaction function. Powell said, “The downside risks to employment have increased. If the labour market were to slow unexpectedly,” the Fed is able to “react to that by cutting faster”. “The US economy is in a good place,” he said. “And our decision today is designed to keep it there”.

Short-term yields are back under pressure, the dollar is selling off against its major counterparts, and equity futures are kicking higher ahead of the North American open as investors abandon hedges on a US recession and double down on an expected narrowing in global growth differentials. With expectations for the Bank of Canada moving in sympathy, the Canadian dollar is trading in the middle of its recent range, generally failing to capitalise on the greenback's retreat.

The British pound is trading near a two-year high after the Bank of England held rates, as expected, and said it would move cautiously in months ahead. Monetary Policy Committee members voted by an eight-to-one majority to leave rates unchanged, with arch-dove Swati Dhingra continuing to lobby for a cut. Governor Andrew Bailey suggested that policy should remain restrictive for “sufficiently long”, and the statement language was modified to say “In the absence of material developments, a gradual approach to removing policy restraint remains appropriate”. Traders moved to reinforce odds on a quarterly pace of rate cuts - far slower than in the US - and the exchange rate surged more than 0.8 percent, topping levels last hit in early 2022.

With the Bank of Japan set to leave policy unchanged in tomorrow’s decision, the yen is trading substantially below its recent highs. Officials are widely expected to echo the hawkish tone that has pervaded recent appearances, but with cross-Pacific rate differentials showing signs of stabilisation, the fuel for continued currency appreciation is rapidly evaporating.

Beyond Japan’s rate decision, the data calendar through the end of next week looks relatively tame. Market participants will use information contained in next Thursday’s weekly claims report and the durable goods orders release to help fine-tune economic models, but neither is likely to materially shift rate expectations. The heat has already been taken out of Friday’s personal consumption expenditures print by previously-released data, with major surprises now looking distinctly unlikely.

Volatility could ratchet higher in coming months as incoming data trigger adjustments in the expected pace of easing. But we also suspect that market focus will now turn toward the US presidential election, which remains tightly-fought, and highly consequential for foreign exchange markets. As it stands, the likelihood of a sweep - a capture of the House, Senate, and White House by a single party - is well below levels seen during the summer months, suggesting that the next US president will struggle to enact economic policy changes that require congressional support.

It’s important to note that gridlock is generally good for the US economy. The victor in November’s election will retain the capacity to raise trade barriers, and currencies outside the US could land in the firing line once again. But spending will remain elevated - fiscal conservatives are a rare breed on both ends of the US political spectrum - and the flow of government cash into the US economy is unlikely to slow in a material fashion. This suggests that the dollar’s outperformance might resume once markets have adapted to the Fed’s newly-adjusted reaction function.

*Please note: No morning market brief will be sent tomorrow morning - we’ll be back in your inbox on Monday.

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