Charlie Jamieson, Chief Investment Officer

The move towards a global ­interest-rate-cutting cycle has commenced.

Last week both the Bank of Canada and the European Central Bank cut interest rates for the first time since the pandemic, with the Bank of England expected to follow in short order.

This will bring five of the G7 ­nations into active rate-cutting cycles, sparking considerable debate about when the US might join this trend.

As firm believers in market and economic cycles, we recognise that interest rate cuts are implemented at this stage of the cycle to attempt to smooth the outcomes that restrictive policy brings to economies. Rate hikes were delivered to slow growth and thereby inflation, a goal that has been broadly achieved.

Despite some pushback at times, we have maintained that a non-stimulatory rate-cutting cycle would commence around mid-year, reflecting the significant progress in reducing inflation since its peak during the reopening phase in 2022.

For instance, Canada’s inflation rate has dropped from 8.1 per cent to 2.7 per cent, the Eurozone’s from 10.6 per cent, to 2.4 per cent, and the UK’s from 11.1 per cent to 2.3 per cent. These rate cuts reflect that much of the inflation fight is now over and some easing of the economic reins can commence.

While the inflation beast has been slain, some embers of the ­inflation fire remain, necessitating a cautious approach to interest rate cuts.

In Australia, the RBA is unlikely to consider rate cuts until November, as it awaits the Q3 quarterly inflation report delivered in October to confirm a steady decline towards the target.

This caution is often described as “data dependency”. As central bank modelling of the economy was inadequate during the Covid period, trust in their own academic modelling collapsed.

We are sympathetic to this. Covid disrupted the economy like a jigsaw puzzle thrown into the air – scattering pieces and making it difficult to obtain clear data and trends for a prolonged period.

Usually, central bank models predict general trends in growth and inflation, enabling policy ­decisions to be made in advance with optimised timing to address current needs.

However, we now follow a more cautious and data-dependent approach.

This new phase of data dependency involves waiting for actual data, shifting policy in real time rather than relying on forward ­estimates.

This approach can result in policy decisions “behind the curve,’’ as delayed adjustment may not affect the economy fast enough to temper a particular ­series of trends. For example, post-Covid reopening saw a surge in ­inflation. With their feet flat out on the accelerators of stimulus, central bankers were very slow to remove policy stimulus as inflation initially rose. This resulted in the most pronounced rate-hiking cycle ever seen, given the relative changes in rates, to crush inflation that occurred with powerful momentum driven by previous over-stimulus.

Now, we may face the reverse effect. As growth slows rapidly, the tempering of inflation usually ­occurs with a lag. Should central bankers wait to see the realisations of lower inflation to gain conviction to cut aggressively, growth may have already fallen too far and may require extraordinary measures to jump-start the economy again.

Consider a small business trying to hang on in this harder part of the economic cycle. At some stage, it becomes unsustainable to keep everyone on the payroll, leading to staff cuts to meet shrinking demand.

These folks are not rehired after the first rate cut, or even the second. If growth falls too far, it creates a negative feedback loop that requires significant policy ­adjustments. This situation could shift the rate-cutting cycle from non-stimulatory – the gentle reduction in rates to elongate the cycle – to a fully stimulatory rate-cutting cycle to jump-start the flatlining patient.

While markets have been confident in a soft landing, this optimism should be tempered as growth in the US, the economic engine room, is slowing. The US will be the ultimate calibration for the depth and speed of the upcoming cutting cycle.

Growth data in the US continues to slow, suggesting its economy is not immune to the broader slowing of the global macro environment. This has led markets to expect that the US Federal Reserve may commence its own rate cuts ahead of the presidential elections, with September emerging as a likely starting point for the US to join the rate-cutting cycle.

We expect the RBA will be a laggard to the cutting party, but this is very likely the next move in their policy series. With global central banks now actively cutting interest rates, this shift in interest rate policy may have significant implications for investors.

Investors should rethink asset allocations, particularly in cash, floating-rate investments and ­exposures to credit risk.

While it’s challenging to forecast the extent of this interest-rate-cutting cycle, history shows once the switch from rate hikes to rate cuts is made, these moves tend to have follow-through momentum for some years.

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