Published in The Australian - 11 February 2024

Investors will enjoy a non-stimulatory interest rate cutting cycle in 2024, with falls expected in most developed markets.

The lower rates will match victories in bringing global inflation to heel, helping to buoy many asset markets with improved financing conditions at a nominal interest rate level.

Global central bankers have been explicit in their plans to turn policy in the rate-cutting direction to match the step down in inflation, a seismic change from the last few years of hikes.

With China still grappling with deflation and excess capacity, the trend of global improvements in inflation outcomes is likely to persist.

As China looks to export cheap goods and excess capacity to the world, it fuels substantial global competition, which can alleviate price pressures.

This suggests that peak interest rates are upon us (the terminal rate), with implications for asset allocation within fixed income.

Historical data suggests that moving from floating to fixed rate exposures leads to outperformance in subsequent multi-year periods.

While markets and commentators fixate on the timing and magnitude of interest rate cuts, oscillating around each data print as if it were totally binary, the reality is that such cuts are warranted regardless of short-term data fluctuations.

It’s probable that these cuts will occur, most likely in the second quarter, spearheaded by the US Federal Reserve and the European Central Bank.

The ECB is compelled to lower interest rates due to the recessionary pressures weighing on its economies. Meanwhile, the US Federal Reserve aims to execute rate cuts before the election cycle to remain apolitical.

Central bankers are keen to avoid repeating the mistakes of the Global Financial Crisis: if rates are left overly restrictive for too long, then economies can have a nasty accident. Taking pre-emptive measures by moderately lowering rates now – perhaps by a slight margin such as 1 per cent – after a series of rate hikes (exceeding 5 per cent in the US) can help to elongate the cycle and avoid a harder economic landing at a later date (like the mild cutting cycle of 1995).

Should they let the economy stall by staying overly restrictive with interest rates in the near term, central banks risk a larger problem at a later date, which has historically required rates to be slashed by 3 to 5 per cent to jump-start the economic patient with a larger defibrillator.

Also on the minds of central bankers is the pending credit cycle, which grows in importance as the year progresses. Corporations did a great job of extending their maturities on debt obligations during the pandemic, when the total cost of debt was very cheap and it was rational to lock in debt for longer periods, but there is a large amount of corporate debt that is due for refinancing as we approach 2025 and beyond.

While the initial moves in markets were driven by repricing assets due to duration risk, the next leg of asset performance is hinged on the ability to refinance outstanding credit or debt. Bringing the total cost of debt down is certainly helpful and provides confidence that this can occur in an orderly manner. Corporate credit markets are highly contingent on confidence, tending to act in a pro-cyclical manner, and underperforming around economic weakness when credit availability is often reduced.

We believe that helping to facilitate this refinancing process, which swings into full gear by the later part of this year, will be additional motivation to reduce interest rates, assuming inflation remains contained.

The US economy has enjoyed a strong start to the year, with a lift in activity and employment after waning momentum into late 2023. Conversely, the Australian economy has hit a rough patch, with recent data being extremely soft. Domestic retail sales were shockingly weak at -2.7 per cent on a notional basis (remember including inflation at about 4 per cent plus population growth at about 2 per cent, nominal retail sales should be significantly positive, not -2.7 per cent negative).

Full time employment (always a volatile number) dropped by 106,600 jobs in December and inflation fell significantly faster than both RBA and market expectations. While the reported inflation number focuses on a quarter-on-quarter basis at 4.1 per cent annualised, if we look at a month-on-month calculation (similar to other global markets), the domestic inflation rate is already 3.4 per cent. These developments lead us to believe the RBA can join the global rate-cutting party by the middle of the year, although we do not expect cuts of the same magnitude as in Europe or the US.

This improvement in domestic inflation is likely to continue, green-lighting a rate-cutting bias in the RBA’s policy in coming months. RBA governor Michele Bullock explicitly conveyed this sentiment during a press conference following the bank’s first meeting for 2024, stating: “There’s a question that comes about: when do we reduce the restrictiveness of monetary policy to neutral (rate cuts), and do we have to be in the band (on inflation) at 2.5 per cent before we think about doing that? No, I don’t believe we do.”

Rate cuts are coming, and while we expect that economies will continue to cool from the long and variable lags of monetary policy hikes that are still working their way into everyday life, ironically capital markets can enjoy the look forward to more friendly financing rates than we are currently experiencing.

While juicy term deposits were nice while they lasted, investors should speak to their advisers and contemplate diversifying their alternative asset allocations in a rate-cutting environment where credit risk is percolating as the economic cycle cools.