Synchronized Easing

A synchronized easing cycle in the context of declining inflation creates further upside risk for all risk assets. Developed market central banks are set to cut rates in the coming months, and the impact of their easing may be greater than the sum. Banks and investors hold portfolios across jurisdictions and their risk appetite may further rise as they see their entire portfolio inflate. In addition, major central banks are set to cut rates due to progress on inflation and not economic weakness. The potential for unexpected pockets of weakness skews the distribution towards additional cuts, which could potentially be numerous due to the historically high level of policy rates. This post describes the imminent global easing cycle, notes that distribution of potential future cuts is very asymmetric, and suggests the crash up will continue.

The Swiss Are First

The Swiss National Bank kicked off the developed market central bank cutting cycle with a surprise cut this week, but everyone else is right behind them. Chair Powell showed a clear intention to cut as he dismissed recent inflation readings and reiterated his view that financial conditions are restrictive, despite much evidence to the contrary. ECB’s downward revision of inflation forecasts suggest a first cut in June, and the BOE is also moving towards an easing bias as its most hawkish members no longer seek further hikes. Market pricing is clearing indicating the onset of a synchronized global rate cutting cycle, where the whole may be greater than the sum.

The recent synchronized hiking cycle was perceived to be especially restrictive due to cross-border spillovers, so a synchronized cutting cycle may be also be particularly accommodative. Research on the banking channel of policy transmission suggests that global banks hold diversified portfolios of assets so declines in their net worth due to hikes are moderated by assets holdings in non-hiking jurisdictions. But a synchronized hiking cycle puts downward pressure on their entire portfolio, which reduces capital and leads to greater retrenchment in lending. By the same logic, a synchronized cutting cycle would inflate assets across their portfolios and have a greater easing impact than cuts in any single jurisdiction. Non-bank investors with diversified holdings may also experience a similar effect. Note that synchronized cuts in 2008 and 2020 were followed by strong market gains.

Financial conditions progressively loosened despite historically high policy rates across the world.

Skewed Lower

Unlike the low interest rate era, central banks banks today have significant amounts of room to cut in the event of an economic slowdown. Similar the the SNB, Fed officials have noted that they are moving to cut rates due moderating inflation and not economic weakness. So unexpected economic weakness would lead to even more cuts. Fed officials appear confident that inflation is moving towards target and are becoming more balanced in managing their dual mandate. Economic conditions remain benign, but the risk of a negative economic shock is historically much more likely than a positive one at this stage in the cycle. Economic growth and employment have steadily moderated towards historical trends so a soft patch in the coming months would not be unreasonable.

Central banks widely see inflation moderating towards target.

The Fed’s reaction function suggests that a future economic slowdown would be met with a sizable number of rate cuts. The March dot-plot reveals that Fed officials continue to view the neutral rate to be around 0.5% in real terms, which is around 3.5% in nominal terms given recent surveyed inflation expectations. This suggests that a minimum of 8 25bps cuts would be need to drop policy from 5.3% to a level perceived to be accommodative. A more concerning economic slowdown would correspondingly require even more cuts. Given that policy rates are at peak and the market is pricing in 3 cuts this year, the distribution of future outcomes is skewed towards more cuts. And the potential for more cuts introduces upside risk to all assets.

Still Crashing Up

The macro backdrop remains benign for risk assets, where speculative psychology appears to be taking hold. Fiscal policy remains loose as the popular culture continues to demand more fiscal spending. Longer dated yields appear to be stable, potentially responding an imminent QT tapering. Economic growth remains steady, unemployment remains low, and most importantly the central banks are no longer standing in the way. While the declines in 2008 and 2020 understandably loom large in the memory of many speculators, that is not the only possible path for an upward price trend. There are also periods like the 1990s and 1920s where the market can rise longer and higher than anyone ever imagined.

The Dow tripled in five years during the roaring 20s. But the party eventually did end.