Circle One video: Opportunities in European equities as rate cuts arrive (7:46)
CIO economist Dean Turner lays out the macro outlook and equity opportunity set.

Thought of the day

Investors have once again scaled back their expectations for US rate cuts following the release of strong jobs data on Friday. As of 12 June, investors were pricing around 40 basis points of easing from the Federal Reserve in 2024, down from close to 50 basis points ahead of the employment figures. US Treasuries have also reflected concerns that the Fed will ease policy only marginally this year, with the 10-year yield rising from 4.29% at the start of trading on Friday to around 4.40% at present-though this is down from 4.46% on 11 June.

But the view of investors could pivot again today following the release of US inflation data for May along with the outcome of the Fed’s policy meeting. The market reaction to these developments will likely hinge on several variables:

Investors will be looking for further evidence that core inflation is continuing to trend lower. Progress toward slower inflation, which went into reverse in the first quarter of the year, resumed in April. The core consumer price index-which excludes volatile food and energy prices-rose by a monthly 0.3% in April, down from 0.4% in the prior three months. The consensus forecast is that it will hold steady at that level. But sensitivity to the release is such that investors will be looking one decimal point further. A reading below April’s core reading of 0.29% would likely be reassuring. For markets and Fed officials, there would likely be a significant difference between 0.25% and 0.34%-even if both are rounded to 0.3%. A core reading of 0.2% would probably be well received by investors.

Markets will likely be especially encouraged by data pointing to easing housing costs and wage pressures. Shelter-which accounts for about 40% of the core CPI reading-has continued to exert upward pressure on inflation, led by owners’ equivalent rent. This measure of housing costs tends to be backward looking since rental contracts are typically signed for one or two years. As a result, owners’ equivalent rent has been reflecting the strength of housing demand more than a year ago. Given its heavy weighting in the official inflation data, investors will be hoping for signs that the lagged effect of moderating rental increases will continue to feed through into overall CPI.

The Fed also highlighted the importance of core services excluding shelter. This includes the prices of services such as leisure, hospitality, insurance, and daycare-which tend to have a high wage component. A slowing of this metric could indicate that slowing wage growth is helping to relieve inflationary pressure in these categories.

The Fed’s message at its policy meeting will affect market sentiment over the coming weeks. The most concrete metric for investors will be the quarterly release of the dot plot-which charts the interest rate predictions of top Fed officials. When the dot plot was last published in March, the median forecast by members of the Federal Open Market Committee, which sets policy, was for three quarter-point rate cuts by the end of the year. It is likely that the median forecast will now fall to two cuts, which is also our base case. But as with inflation, investors will be sensitive to the details. A dot plot that only narrowly avoids a decline to one implied rate cut would likely cause more anxiety, as it would suggest a more hawkish tilt to policy. The Fed's updated inflation forecast could also be significant, since a higher trajectory for price rises could slow the pace of Fed cuts.

Finally, the tone of Fed Chair Jerome Powell at the press conference following the rate decision can have a major impact on the mood in markets. His consistent message in recent public appearances has been that rate cuts have been delayed relative to prior expectations but are likely later in the year, assuming officials “have gained greater confidence that inflation is moving sustainably toward 2%.” He has also pointed to evidence that the labor market is getting into better balance. Investors will pick up on even subtle shifts in his language, whether hawkish or dovish.

So, the outcome of today’s developments has the potential to set the tone for markets in the near term. Our base case remains that with the trend toward slowing inflation back on track, the Fed will cut rates twice this year starting in September. Against a backdrop of cooling growth and rate cuts, we are most preferred on quality bonds, where investors can lock in attractive yields. With the return on cash deposits likely to fall, investors should consider strategies to manage their liquidity.