How central banks’ rate cuts impact riskier assets

However, the market can get too much of a good thing because, if rate cuts become large and rapid, they are likely to produce the opposite response in riskier assets. As things stand right now, the market seems to be straddling these two outcomes. We have always lent to the more optimistic, or glass-half-full, version of this story, and we still do. But the risks of a glass-half-empty outcome are rising.

Modest and steady rate cuts from central banks, of the sort the Bank of Canada did, with its third consecutive 25-bps rate reduction, appear consistent with a soft-landing scenario and robustness in risk assets. But if the BoC and other central banks have to adopt much larger, or more frequent rate cuts, it would likely reflect a hard landing, and that’s not positive at all for risky assets. So, while some investors might see a possible 50-bps rate cut from the Fed at the September 18^th meeting as positive for asset prices, we doubt that this is going to be the case if the large cut reflects a notable deterioration in the economy, or at least in the labour market.

In contrast, if the labour market appears more robust and the Fed ‘only’ cuts 25-bps, the more modest outcome might actually be better for risk assets, not worse. Of course, much depends on market expectations. If analysts and market pricing are set up for a 50-bps cut and the Fed only delivers 25-bps, we dare say that riskier assets would suffer. But the Standard Bank’s assumption for the glass-half-full view is that the market largely anticipates a 25-bps rate cut, and this is what the Fed delivers.

This being said, there are two caveats. One relates to the yen-funded carry-trade and the other to central bank preferences when it comes to an easing cycle. The first of these, the carry trade, reflects the fact that the early August stock market and yen scare suggests that it might be the BoJ that’s the most important central bank here not the Fed - and it is hiking rates, not cutting them.

In other words, for all the good a modest and steady Fed rate cut profile might be for riskier assets, the BoJ may blow all of this out of the water should its rate hikes create enormous carry-trade unwinding. For while the early-August surge in the yen and slump in stocks might have looked to some like a one-off, with short-term speculators now devoid of any significant carry-trade positions, there is a view that the carnage was just a taster of what’s to come.

Decades of investment in overseas assets from recycled Japanese trade and current account surpluses could go into reverse as Japanese rates and the yen rise. Clearly, we can’t say for sure that this will happen, and, even if there is significant repatriation, it might not lift the yen substantially if investments have been made on a hedged basis. Nonetheless, carry trade unwinding does represent a serious threat to any rosy view of risk assets going forward.

A second difficulty that could arise in the more optimistic scenario is that central banks tend to be more aggressive in their tightening and easing cycles than generally anticipated by the market. Hence, with rate cuts looming ahead, the Standard Bank feels that central banks are most likely to go a little harder and faster than the market expects.

For instance, even though we are sceptical that the Fed will start with a 50-bps rate cut, we do look for the easing cycle to speed up to this size of rate cut further out, and that’s not priced in by the market. Importantly, the Standard Bank does not take this view because it sees a material slump in the US economy, or any other for that matter. Instead, it is a view based on the history of how central banks conduct tightening and easing cycles, and, on this basis, it does not think a faster pace will cause undue alarm. That allows us to stick with the glass-half-full view of economic performance, policy easing - and trends in riskier assets.