What will happen to stocks if the central banks don’t cut rates?

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Stocks and the price of other risk assets were pushed higher at the end of last year, and have continued to rally, as Jerome Powell, Federal Reserve (Fed) chair, promised rate cuts in the near future. While the message wasn’t as explicit at the Bank of England or European Central Bank (ECB), the market expects them to follow suit.

Current market pricing indicates a 135 basis point (bp) reduction in the Fed funds rate by the end of the year, the same for the ECB, and 100bp off the Bank of England's policy rate.

Chart 1 - Market expectations for central bank policy rates

Historically, this magnitude of easing has only occurred when the economy has toppled into recession, and when corporate earnings and stock prices have, at least initially, been falling alongside interest rates.

Chart 2 - Federal Reserve policy rate and US recessions

Has the bond market therefore gotten carried away by looking for so many cuts alongside a soft landing? And if central banks don’t cut, what does it mean for stocks and other risk assets?

Once again the answer to our question boils down to what we learn in the coming weeks and months about inflation, since a shift in the Fed's projections of inflation played a pivotal role in its shift in tone.

Indeed Jerome Powell seemed pretty confident at his December press conference that inflation was on its way back to 2% – despite resilient activity. The argument then follows that the Fed didn't clearly need to be holding rates in what it perceives to be restrictive territory and could shift back to neutral. The Fed (unwisely in my view) is one of the few central banks that states publically what it believes the ‘neutral’ rate to be (2.5%). The market has therefore interpreted his comments to mean that the Fed will quickly return its policy rate towards the neutral rate.

The problem will come if inflation proves stickier than expected. Inflation, after all, is essentially the economy’s traffic light. Inflation that is too hot is a red light saying that things needs to slow down. When it’s too low, the economy can safely speed up. If inflation does prove sticky, this will be a clear indication that growth still needs to slow which will not be good news for corporate earnings or stocks.

Both headline and core inflation are currently proving very volatile due to problems in seasonal adjustment and big moves in some of the noisier components like package holidays. The central banks really should focus on wage growth which is the most reliable indicator of underlying medium-term capacity problems and inflationary pressure. If falling headline inflation quickly translates into weaker pay pressures, despite record low unemployment, then we could sustainably be en route back to 2% inflation. But it’s equally possible that workers will continue to use record low unemployment as a bargaining tool to secure more pay and compensate themselves for earlier losses in real spending power. We simply don’t know which way it will go so wage growth data requires scrutiny.

Furthermore, cost of living pressures won’t be falling if tensions in the Middle East see energy and goods prices starting to rise again. Goods price deflation has been a key driver of falling inflation so this needs careful monitoring.

Chart 3 - US goods and services inflation

Overall we should be somewhat wary of the current disparity between bond and equity market pricing and prepared for a minor reality adjustment in both markets.

Explore our Guide to the Markets here.

All data is sourced J.P. Morgan Asset Management as of 30 January 2024.

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