Back-to-school cuts for central banks and the latest political developments

Discover the latest views on the hot topics of the moment from Natixis CIB Research’s Monthly Preview.

With a quick look across the Atlantic following the Fed’s decision to cut rates on September 18th, the 50bps cut was stronger than the Natixis CIB’s scenario, but in line with market expectations. Going forward, we expect to see sequential 25bps cuts until September 2025, at which point the Fed Funds rate will have reached 3%. While the US economy has slowed, we do not expect a recession.

Moving to the Eurozone, the picture is not too different, although sequential growth is lower. Despite the current soft patch, we continue to expect a moderate pick-up in growth and the current sluggishness seen in the euro area is temporary. Growth risk, however, remain titled to the downside, not least because the external environment remains complicated.

The fundamental case for growth in the euro area relies on the strong rebound in disposable income. The labour market is doing fine, wage growth has been solid, and inflation has come down, which translates into strong income growth. Consumer spending ,however, has been growing less forceful than we expected, which is why recovery has been more muted than anticipated. For the time being, a rise in savings rates which have reached a record high – excluding the pandemic period – is having a negative impact on the effect of strong income growth.

Headline inflation is close to target, having made significant declines. That being said, the momentum of monthly core inflation has increased and remains relatively high. Continuing high wage growth is driving the stickiness in services inflation. But on a positive note, we have seen wage growth moderate quite a bit, even if the level is still very high. We need to see further moderation in wage growth for services inflation to decline, and we expect that moderation to happen because headline inflation has come down sharply. This decline in services inflation will allow the ECB to continue its gradual easing and we see the terminal rate for the ECB at 2.25%, being reached in July 2025.

Taking a quick look at what lies ahead for France in the coming weeks and months, there are a couple of important events coming up, now that the government has been formed. The budget will be the main focus for markets, given that the French deficit remain high at 5.6% of GDP. Eventually, that figure has to come down to 3% to comply with the European rules. It will be interesting to see what kind of fiscal plan will be proposed, and how credible that plan is.

Since the summer, there has been a strong refocus from the market on macro risk, with downward revisions everywhere – especially in China, but also with concerns from the US job market which is slowing down.

We have seen a rise of volatility, correlations, the various risk perception indicators and a widening of credit spreads. Risk indicators have only partially receded since August. At the same time, we have seen a strong bond rally, with inflation de-pricing and in line with this, a drop in oil prices on the back of concerns related to global demand for commodities in the current environment, and a strong repricing by the more aggressive central banks. Looking at macro factor diffusion, growth and defensive factor are gaining momentum, while inflation factor, is losing momentum.

September brought a rebound in risk appetite and a decrease in volatility. But before the Fed’s rate cute, the market was still in a defensive rotation. There were significant inflows to bonds while inflows to equity were starting to slow. Equity relative performances also were showing a rotation from cyclicals to defensives.

Can the Fed change this market momentum? Looking at past episodes of fed cutting cycles and asset performances before and after first cuts, we have distinguished that the macro-outcomes (soft landing, recession…) matter for risk assets. Even in soft-ish recessions, the Fed cut did not prevent equity shock, while in soft landing scenarios, we still saw equity markets rise after the cut. Which leads us to understand that while the Fed is key, what matters for the upcoming months, is the macro outcome. On the bond side, the current T-note pattern is consistent with what happened in the past and is less dependent of the macro outcome.

The key question now is, will we have the soft-landing scenario that the market expects and what could it mean in terms of asset performances? In terms of asset patterns, the soft landing scenario that was realized in 1995 is somewhat comparable to today’s situation in terms of market behavior. Interestingly, diversified 60/40 portfolio continued to perform after the first cut in 1995.

What does differ between the scenario today and in 1995 is the performance of equities vs bonds. Today, we had a strong outperformance of equities compared to bonds before the Fed’s first cut, while the outperformance was not as strong back in 1995.  This could mean there is still some room left for bonds to outperform vs equities.

For small -caps vs large-caps, the pattern was similar to the previous soft landing scenario in that around the first cut we also had a small-cap rebound – but it was short lived and chaotic. This is consistent with our view that small caps’ bullish view might be short-termist in the current environment.

The dollar is weakening but it remains strong. It has declined since the beginning of the summer but increased during the first half of the year on the back of stronger inflation.

The dollar DXY index started to decline in July, and we are now testing the important level of 100 – for the time being it has not dropped below, but we will likely see this happen next year.

The dollar index remain quite high historically – particularly compared to 2010 levels, and the dollar remains overvalued.

Since the beginning of the summer, all the G10 currencies have increased against the dollar.  The Yen increased the most – due to the surprise rates increase from the Bank of Japan in July, which lead to a technical rebound.  

The drivers of the dollar’s decline are primarily activity in the rates market. There is strong correlation between the dollar DXY and US 10-year rates, so when the market started to have increased  expectation that the Fed would cut rates, the US 10y Rates started to decline and so too did the strength of the dollar. That said, we don’t expect to see a big fall in the Dollar by year’s end, as the market has already priced many Fed Funds rate cuts expectations. In the medium term, the trend is still negative given that US growth is expected to further disappoint, but like this year, the decline will be limited given many things are already priced-in for next year. In order to see a big fall in the dollar, we’d need to see a recession – which is not our scenario.

For the Euro-dollar, the market is becoming more positive on the Euro, following a short position in Q2. We don’t expect to see a big rise in euro-dollar – it will remain more or less stable until the end of the year, sitting at somewhere around 1,11. Factors that will impact include US data, particularly labor data. Looking to next year, we expect the euro to increase towards 1,14. Considering that many things have already been priced, it is not a big increase.

Turing to Japan, the yen has declined quite significantly after testing 156 in Q2, on the back of higher US rates. The decline began in June following the BoJ’s intervention in the forex market. Then weaker dollar due to a more dovish Fed and the surprise rate hike of the BOJ led to a big deleveraging in short positions in the Yen. We expect the dollar-yen to remain  quite rangy for now between 140-145. Looking to next year, we expect the Yen to decline further.