Equities rallied back from last week's declines, while lower US yields ahead of the start of the Fed's easing cycle at next week's meeting weighed on the dollar. Markets leaning towards a 50bps cut sent the benchmark 2-year Treasury yield to lows since mid-2022, with further downside in prospect in the event of a dovish Fed meeting. Other events of note next week include policy meetings for the BoJ (Fri) and BoE (Thu); US retail sales (Tue); inflation data in the UK and euro area (Wed); and Australia's monthly labour force report (Thu).
Odds back in favour of a 50bps Fed cut
The debate over whether the Fed will commence its easing cycle with either a 25 or a 50bps cut is set to continue all the way until the decision is handed down next week. Markets have swung back and forth as the incoming data has failed to give a clear steer. CPI data for August came in on consensus for the headline measure at 0.2%m/m and 2.5%y/y, down from 2.9%y/y previously, but a slight upside surprise for core inflation in the month at 0.3% (vs 0.2%) left the annual pace steady at 3.2%. This saw markets repricing for a 25bps cut; however, by the end of the week, the odds were back in favour of a 50bps move.
Dovish bets were reinvigorated by media commentary and reports amid the Fed's pre-meeting blackout period. Influential former NY Fed President Dudley said he saw the case for a 50bps cut, while an article from the WSJ's top Fed watcher Timiraos outlined that the 25 vs 50bps debate was still very much live. My own view is that the developments the Fed has seen in the labour market of late, with rising unemployment and downward revisions to employment growth will lead the Fed to cut by 50bps.
ECB cuts but remains cautious
The ECB's decision to cut its key policy rate by 25bps to 3.5% had been fully discounted by markets going into this week's meeting. With growth slowing and inflation remaining on track to return to target in the back half of next year, the Governing Council continued the process of 'moderating the degree of monetary policy restriction'. Larger cuts (60bps) will go through to the ECB's other rates: Marginal Lending Facility to 3.9% and Main Refinancing Operations to 3.65%, changes that stem from a review tabled earlier in the year that recommended the ECB's corridor system of rates operate with narrower spreads (15bps from 50bps), effective from September.
This was the second cut of the cycle and President Lagarde said during the post-meeting press conference that policy is 'pretty obviously (on) a declining path'. New staff projections retained the outlook for headline inflation to fall to 2.5% this year, 2.2% in 2025 and 1.9% in 2026; however, progress on core inflation was seen as less convincing due to services prices surprising on the upside recently. Those forecasts were revised up to 2.9% in 2024 (from 2.8%) and 2.3% in 2025 (from 2.2%). That leaves the Governing Council conveying an underlying sense of caution on the pace of rate cuts, reiterating a data-dependent stance and decisions being taken on a meeting-by-meeting basis.
Market pricing leans towards another two rate cuts by year-end, a scenario that to be met would require the ECB to ease more aggressively than it has so far. That is not out of the question given downgrades to the growth outlook were made across the projection horizon: 0.8% in 2024 (from 0.9%), 1.3% in 2025 (from 1.4%) and 1.5% in 2026 (from 1.6%). Meanwhile, a Bloomberg article quoting ECB sources indicated a rate cut in October was not being ruled out.
Inflation still the main game for the RBA
Insights on the Australian labour market in a speech from the RBA's Assistant Governor Hunter implied that inflation remains of much greater concern - a contrasting scenario to many of its central bank peers. Suggesting as much, Hunter highlighted that the labour market - though rebalancing - is still tight relative to the RBA's assessment of full employment, and the overall resilience of conditions amid the economic slowdown had surprised. The RBA forecasts the unemployment rate (4.2% as of July) to edge up to a peak of 4.4% over the coming year. As Hunter explained, a key part of that assessment is the view that vacancies can moderate from elevated levels to prevent a steeper rise in unemployment. While the RBA is wary of a more pessimistic scenario unfolding, it will need to see this emerging in the data - starting with next week's August labour force survey - to shift more of the policy focus to the employment side of the mandate.
There was a potential warning light on this front as households highlighted some increased concern around the labour market in the Westpac-Melbourne Institute Index September report. This contributed to an easing of consumer sentiment (-0.5%) in the month, with the index (84.6) remaining in its deeply pessimistic range of the past couple of years. Meanwhile, the NAB Business Survey reported a softening in trading conditions and a weakening in confidence in August, both indicative of the subdued growth backdrop reported in last week's National Accounts for the June quarter.