While most analysts were holding the view that the American economy is fine, there is no recession right now or even on the horizon, a soft landing with a 25 basis point cut was turning up to be the consensus view. But now things have slightly changed in the run-up to the FOMC meet. Have not they? A 50 basis point rate cut does not seem completely unlikely.
Manish Singh: No, it is not unlikely and we are going to get that and it is justified. Because if you look at where the two-year rate is, the two-year treasury yield is at 3.57% and the upper bound of the Fed fund rate is 5.5%, so we are talking about 190 basis point spread. You have to go back to 2008 to see the spread this wide.
Of course, at that time, you know that there was a crisis going on and we got 75 basis point cuts. Now, of course, we are not going to get 75 basis point cuts now because there is no crisis going on. But the reason why I think Fed is going to cut 50 and why it should cut 50 is that if the inflation is on track to be at 2%, it is at 2.5% now, what justifies the rates being this restrictive, we have seen the most rapid increase in rates in the last 40 years. The rates have been at 5.25% for 14 months. What justifies it being at this high restrictive level? There is no point. So, I think for that reason you are going to get 50 basis point cut.
But what do the markets really want? At the launch of the first rate cut cycle in four years, the first since 2020, since the pandemic hit us, what is the best case scenario for the equity markets right now?
Manish Singh: Well, I would say it depends on who you ask. For me, 50 basis points is the right thing to do. The swing and roundabouts you are seeing in the market prediction of a rate cut of 25-50 bps is just down to short-term tradings and futures that you see in rates market. That should not be a determining factor in whether it should be.
What the market is going to look for is that that 50 basis point cut comes with a narrative which says that this is the right thing to do, the rates are very restrictive, but it does not come with the view that we are trying to avert a recession, which is not my best case scenario. Because if you look at where the leverage in the housing market is at all-time low, 27%.
Of course, the stock market is at an all-time high, and that gives you a wealth effect. Housing prices have increased a lot over the last three or four years, that is giving you wealth effect. You are still earning 5% on deposit, so that is giving you the income effect. You have 10% of US deficit being run on a federal level, that is going to come into spending and that is going to come into the economy. So, I do not see a recession coming over next six months.But what comes through in the commentary it is going to be crucial, isn’t it? What are the reasons you would see them ascribe to a rate cut this time? Do you think they will say it is because inflation is climbing down or will they allude to any kind of recessionary trends because any mention of the need to fight a recession could spook the markets?
Manish Singh: Yes, and I do not think there is need to even mention that, because if you look at where the jobs report is, we saw at the job openings for number of unemployed, that has gone down from two to one, that has been cut into half. Total job openings is at 7.6 million, which is the pre-COVID level. In fact, if you look at the FOMC members, their own projection of where the unemployment rate should be at the end of this year, the unemployment rate is higher than that. So, there is a very genuine and good reason that why they should be cutting rates by 50 basis point and the market should not panic because those conditions have been met and therefore, the rate should come down.Besides keeping prices in check, the Fed wants to ensure that employment levels are high and it seems like the Fed is trying to work more on jobs than inflation. Would that be a correct reading at this time?
Manish Singh: Yes, the focus has shifted to jobs and economy and it should shift to jobs. And if it was not for US election, which is the elephant in the room, and I do not think they are going to talk about it, then I think that rate cut would have started last July. The only thing that Fed is wary about is that depending on the outcome of that election, let us say, for instance, we think that President Trump comes back, and he puts tariff and inflation goes up from 2.5% to even 3% or 3.5%, then Fed cannot cut rates, but that will be just wrong thing to do and that is the complication which they will have to bear in mind as they (2:56) tide through this FOMC meeting and the next one closer to the election.
So, between September and the end of this calendar year, by which time, of course, the American election should be done, how many rate cuts are you seeing come through? What do you reckon is going to be the quantum of each cut as well?
Manish Singh: If we look at the projections and we can go by SEB that we have had so far and various commentaries from the FOMC members, 100 basis points by the end of this year, cut by the end of this year, looks on the table. Whether it goes 50, 25, 25 or it is 25, 50, 25 is a different matter. But it does come down to that that is what Fed is targeting, that is what the FOMC members are targeting. But if you look at the overall cycle, where the rates could go to, look at two-year rate, two-year rate has always been a good predictor of where the Fed fund rate should be eventually and that is 3.5.
So, we are talking about at least 175 to 200 basis point cut this cycle. Now that could happen over the next 9 or 12 months, not necessarily over the next six months.
Interest rates go down in an economy, things become cheaper to borrow. Households are more inclined to buy more goods and services and then businesses have that rise in demand that they seek to borrow more funds, expand operations, perhaps build higher capacities with more equipment, etc. They would invest in newer projects and then they create more jobs and then wages rise as well. Is that what you see happening this time with the American economy?
Manish Singh: No, that is what is likely going to play out. I find it very hard to make a case for recession in the present circumstances. As I have mentioned, the federal deficit continues to be at 8% to 10%. The deficit number was at a record high. If you have money being spent, you are not going to see a recession. The only point is going to lead to inflation because money supply is expanding and those things have been taken care of in the sense that the supplies have improved, the job market is not as tight as it was in the past, so those things have been taken care of.
So, it is a very difficult case to make that recession is going to happen. What you are really going to see a continued growth, which means that equities are going to go higher.
Yes, but one of the moving pieces, is the outcome of the American presidential elections. But this is a time that we are also seeing the Chinese dragon not spewing fire. In fact, quite the contrary, China is dealing with a real estate crisis, their manufacturing is slowing down. Equity markets are going to be looking at the American economy that much more closely and get affected by how the Fed takes its decision.
Manish Singh: Well, that is certainly the case, because the world market looks at what Fed does and what happens to dollar, what happens to oil, to take their cue. But remember, a lot of thing is about sentiments. You can easily turn a bullish argument to bearish argument by just using a different set of statistics. So, I would say that not to focus too much on short-term market moves, we saw the yen carry trade unwind that happened in August and then people bought back equities.
The Japanese yen actually is much stronger today than it was in August. From there, it went from 160 to 140, for today is 140. So, yen is stronger and the equity has gone higher. How do you explain that? So, it is not just about one or two data points how that impacts. So, I like to look at what is happening over 6 to 12 months and on that basis I just do not see concerned about where recession or economic stagnation is going to come from.
On the contrary, if there is a deal between US and China, which may happen after the election, then you might have renewed growth.
But since you are talking about currencies, typically, the US dollar would weaken with a rate cut cycle and help other global currencies to rise. Is that the case this time or do you see a capping of the downside on the dollar? Is this scenario different?
Manish Singh: I am not an FX guy, and it is very difficult to put targets where things are going to be. But I would imagine that interest rate parity differentials are going to play out and you will have dollar a bit weaker.
Gold has a negative relationship with bond yields because most of the demand is for investment purposes and right now we are seeing gold at record highs. Do you think gold prices are going to rally higher with Fed rate cuts?
Manish Singh: From what I read, gold is being bought by central banks, China, Middle East as well. So, if the buying is happening for stocking levels, then it just does not matter where the rates are, if central bank comes into buying gold. It is difficult for one to say where it is going to be. But as I have always maintained, that gold is your ultimate insurance, it does have a place in the portfolio, but not for return reasons, but for insurance reasons.