Macro Trader: The Biggest Risk To The Bullish Backdrop

I’ve spent some time now harping on about a number of bigger picture policy thoughts in these pages. Namely, that rate cuts are coming this year from almost all DM central banks, that liquidity is plentiful and should remain so, and that the flexibility that policymakers have engineered for themselves means that, for all intents and purposes, they can take almost any policy course they desire over the next six months or so.

Putting all that together produces a bullish backdrop for risk sentiment, with market participants safe in the knowledge that financial conditions should continue to move to a less restrictive stance, that central banks – as they have proven many times this cycle – will step in to provide targeted liquidity where, and indeed if, it is necessary, and that the economy, particularly in the US, should stick the ‘soft landing’.

However, what if we’re all focused on the wrong thing?

Last week’s CPI and PPI reports served as a useful reminder that, while well on our way to price stability being restored, the ‘last mile’ back to policymakers’ 2% targets may indeed prove to be the lumpiest, the bumpiest, and the most difficult.

Nevertheless, one must recall that policymakers across DM have, on numerous occasions, stated that they are not looking for that mythical 2% CPI print before delivering the first rate cut. Instead, they are seeking additional data to provide ‘confidence’ that price pressures are indeed suitably squeezed out of the economy, in order to ensure that the 2% target will be achieved in a reasonable time frame.

To these ends, while hotter-than-expected January inflation data was a rather unpleasant surprise, it may simply delay, rather than derail, the journey towards the first cut; though, of course, the caveat that policymakers will be loathe to over-react to a single datapoint must apply.

In any case, as noted on several occasions now, whether that first Fed cut (which will likely open the floodgates for G10 peers to follow suit) comes in May, June, or July, matters little for the longer-term outlook for risk.

Instead, what is likely of much more importance, and the crucial factor upon which the above-mentioned bullish narrative rests, is that the easing cycle, when it begins, will return policy to a neutral setting, removing some of the necessary restriction rapidly introduced in order to tame post-pandemic inflation.

This return to neutral is precisely what markets currently price, with the first 25bp cut being followed by further such cuts at each following FOMC meeting, before rates bottom out around 3.5% - 3.75% in mid-2025, and remain there. To get below a neutral policy setting would, presumably, come as a result of some degree of financial instability, which is clearly not the base case at present.

That said, it is here that a potential problem may lie. If inflation does indeed prove stickier than expected, and settles above the 2% target, central banks will have no reason to reduce rates to such an extent, particularly if economic activity holds up as well as it currently is (stateside, at least), and if labour markets remain as tight as at present.

It is here that the ‘cut to neutral and stay there’ base case could morph into a ‘1998 redux’ one and, most importantly, where the biggest risk to markets may lie. Back then, the FOMC began an easing cycle with the first 25bp cut in autumn. However, said cycle was brought to a halt after just three such cuts, i.e. 75bp of easing in total, before a rate hikes then resumed less than nine months after the first cut had taken place.

This start-stop easing cycle would, probably, be the worst of all worlds for riskier assets, particularly coming at a time when participants have begun to substantially up risk exposure safe in the knowledge that the central bank put is back alive and well; an assumption that an on-again off-again cutting cycle would clearly upend.

Hence, when digesting incoming economic data, and when attempting to gauge the impact of such data on the policy outlook, particularly when it comes to the impact of hotter-than-expected, and potentially stickier inflation figures, much more value can likely be gleamed from looking at the 12-18 month dated OIS and fed fund futures, rather than frenetically worrying about whether the first cut will be pushed back by six weeks or so.

All the time that markets remain of the view that a prolonged easing cycle, returning rates to neutral, and leaving rates there, is on the cards, the path of least resistance should continue to point to the upside for equities, and dips are likely to be well-bought. If, or indeed when, this assumption begins to be challenged, stiffer headwinds facing the market are likely to emerge.