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Eddy's Weekly Market Insight

Friday, 20 September 2024

The financial markets have been fluctuating for some time now, oscillating between expectations of significant interest rate cuts and more moderate reductions over the coming quarters and years. This is primarily due to inflation having surged too high after the COVID-19 crisis, prompting a need to restrain growth below potential growth levels. Central banks responded by significantly raising interest rates, which typically leads to much lower growth after a few quarters. Interest rates were raised so aggressively that many began fearing a looming recession – something that must be avoided, as it could easily escalate into another credit crisis in the current environment. However, something quite different has played out in reality. 

Growth, at least in the U.S., hasn’t slowed down much, while inflation has significantly dropped. This decline in inflation occurred because, following the pandemic, the supply side of the economy has almost fully recovered. Does this mean that interest rates can remain at their current high levels?

No, because with stable nominal interest rates and declining inflation, real interest rates rise. This means the economy is being further restrained monetarily, which could eventually lead to a slowdown in growth. Therefore, it’s widely expected that the Federal Reserve will significantly lower interest rates. Many believe this will occur by mid-2025, bringing rates down to around 3%, the level at which the economy is neither constrained nor stimulated.

The challenge, however, is that no one knows exactly where this equilibrium rate lies. It may be much lower or higher than assumed. This has become increasingly important because, until recently, the markets expected that the rise in real interest rates would cause growth to slow rapidly, prompting swift rate cuts to avoid a recession. Yet, according to the latest data, the U.S. economy is still growing at around 3%, while potential growth is closer to 2%. To prevent inflation from resurging, growth must slow down soon.

This risk is further heightened by the possibility of a sudden spike in oil prices due to ongoing conflicts in Ukraine and the Middle East.

As a result, both the Federal Reserve and the markets face a major dilemma: Will growth finally slow down, or is the neutral interest rate much higher than previously thought, meaning rates can only be reduced minimally, if at all? No one has the definitive answer yet, but based on recent figures, this neutral rate appears to be higher than what the markets had anticipated.

We also believe that long-term interest rates are more likely to rise than fall in the near future—especially in the U.S. compared to Europe, where the economy is much weaker. This suggests we’ll see the euro/dollar exchange rate decline rather than rise. For equities, this creates two opposing forces in the short term: higher-than-expected growth but also higher interest rates. However, caution is advised against projecting strong growth far into the future, as the Fed will inevitably aim to bring growth back to 2% to avoid rising inflation.