Currencies: Narrowing but lasting rate advantage

By frontloading its policy easing cycle, the Fed has not only caught up to peers such as the European Central Bank in terms of rate cuts delivered so far, but is likely to outpace them this year by taking a larger step again in the November meeting and reducing rates by another 75 bps before year-end. This would lead to a quicker narrowing of the US dollar’s interest rate advantage, which is mirrored in a currently weaker EUR/USD exchange rate of 1.11 and a US Dollar Index (DXY) close to 100. With the levelling off in mid-2025 at a Fed funds target rate range of 3.25%–3.50%, peers should be able to catch up and the rate differential should widen once again in favour of the US dollar. For instance, we expect the European Central Bank to reduce rates by an additional 125 bps by June next year.

Despite the current weaker levels, we believe that a slightly narrowing rate differential alone is not sufficient to induce sustained US dollar weakness. Indeed, the dovish Fed has wiped out US dollar enthusiasm. However, with an increased probability of a soft landing for the economy, the US retains a growth advantage over some struggling peers such as the eurozone. In addition, the interest rate differentials may be narrowing, but the US dollar should retain its advantage of 125 bps vs the euro up to the end of next year. This means that the US dollar should continue to benefit from relatively higher interest rates. 

Finally, the US dollar also benefits from the superior profitability and earnings of US companies relative to the rest of the world, which continues to attract capital. By comparison, the euro is unlikely to attract more capital as European equities remain highly sensitive to economic risks in a weak economic environment. Hence, we stick to our view that the US dollar can indeed restrengthen somewhat beyond its current weaker levels and maintain our forecast of a rangebound US dollar over the coming months, with a target of EUR/USD 1.08.

Fixed Income: What is the motivation behind the cuts? How many cuts will there be?

What comes next after the Fed’s first rate cut? Well, most likely, the next cut. The bond market’s questions are therefore more about: (i) how many cuts there will be and for how long, and (ii) what is the motivation behind the cuts. In other words, fixed income markets are trying to gauge the new equilibrium in terms of the neutral rate, while also considering the cyclical component that affects yield levels.

First of all, the motivation behind the policy rate cuts matters a lot. As outlined above, the economic backdrop in the US is still solid and pre-emptive rate cuts even increase the probability of a soft landing, i.e. less need for more and even bolder monetary easing later on. The Fed certainly does not want to bring the cost of capital, i.e. yields, back to financial repression levels if it is not forced to. What we have seen during most easing cycles in the past is a Fed conducting ‘emergency cuts’ because something ‘broke’. Given the solid private balance sheets and no signs of endogenous vulnerabilities in the system, we have a valid chance of a different outcome this time. Of course, this is a crucial assumption and, unfortunately, vulnerabilities are often revealed only after the damage has been done. Nevertheless, history suggests that in such a scenario it can well be that policy rates are cut while longer-term yields rise or at least stop falling. The chart depicts the movement of the 10-year US Treasury yield during the easing cycles since 1984, 360 days before and after the first cut.

Chart 1: Positioning of the 10-year US Treasury yield 360 days before and after the first rate cut in a cycle since 1984

We observe that longer-term yields often decline before the actual cuts happen, especially when cuts are well flagged and already anticipated in the curve. Moreover, the window of historical patterns after the first cut is quite open. We have also highlighted the 1995 rate-cutting cycle, often described as the ‘perfect’ soft landing episode.

Readers may recall that the 10-year US Treasury yield has already declined from 5% in October 2023 to 3.7% at the time of writing. As an investor, the obvious question centres around the duration exposure. By definition, as the cutting cycle proceeds, reinvestment risks materialise for shorter-term investments. Naturally, having a substantial amount in very short-term positions becomes less and less attractive and investors want to lock in yields with longer-dated bonds. However, we do not see this as a reason to load up portfolios with very long duration bonds only at this point.

As the 1995 rate-cutting cycle reveals, policy rate cuts along a soft-landing scenario do not necessarily call for much lower long-term yields. Moreover, we should not forget the supply and demand dynamics operating in the US Treasury market. Fiscal deficits are expected to remain remarkably high. As such, substantial Treasury supply is likely to be absorbed by private investors while (price-insensitive) central bank demand is no longer there after quantitative easing. This should also keep some upward pressure on yields.

In a nutshell, we would keep a neutral duration stance at this point, balancing reinvestment and duration risks. Moreover, we would opt for reasonable credit risk exposure with a focus on low-investment-grade debt. Ultimately, corporates will benefit from lower borrowing costs while economic activity remains healthy. Moreover, on the riskier side, we still see value in emerging market hard-currency debt, which should be well positioned to benefit from the cutting cycle in developed markets.

Equities: Monetary easing leads to stock market gains

Historically, US equity markets have shown strong performance during Fed rate-cutting cycles, particularly in the absence of a recession. Analysing data since the 1980s, the S&P 500 has delivered an average return of 14.2% over the 12 months following the initial rate cut, outperforming the average 12-month return of 10.4% over the entire period. This suggests that Fed rate cuts, when not accompanied by an economic downturn, generally create a ‘risk-on’ environment, driving equity gains. However, it is important to recognise that no two cycles are identical.

While the macroeconomic environment generally remains favourable, we expect volatility in equity markets to stay elevated given uncertainty around the upcoming US election, lingering fears of an economic slowdown, as well as seasonal factors. That said, we view the recent volatility as an intermediate correction in a primary uptrend in the secular bull market. While the risk/reward profile for investing into cyclicals has become more compelling, long-term investors should nevertheless stick with US large-cap growth stocks, which are expected to remain the leaders of the secular bull market.

Fed easing cycles have been equally supportive for emerging market (EM) equities. Since 1989, EM stocks have outperformed developed markets by an impressive 27% in the year after a first Fed rate cut that was not followed by a recession. However, US elections are potentially more relevant for the asset class outlook at this stage, as protectionist measures by the Republicans could be particularly harmful. We therefore see no need to rush into EM equities and maintain a Neutral stance on EM equities. We wait for further evidence of a soft landing, fading US election risks, and a weaker US dollar.

Gold and Bitcoin: Recession yes or no, that is the question

Since the start of summer, the focus of the gold market has fully shifted away from Chinese investment demand and central bank buying to the outlook for interest rate cuts in the West. Prices already reached a new record high last week after the European Central Bank cut interest rates a second time, and now the question is, of course, how the Fed’s first cut of a new cycle will impact the gold market going forward. The link between interest rate expectations and the gold market is twofold, via the futures market and via the physical market. Sentiment in the futures market is already very bullish as short-term speculative traders had positioned themselves for lower interest rates some time ago. Meanwhile, activity in the physical market has picked up as the prospect of looser monetary policy prompts safe-haven seekers to stock up, even though the absolute level of interest rates is set to stay high according to our projection.

Looking back at previous US interest rate cutting cycles reveals that lower interest rates alone are not enough to push gold prices higher. Instead, these cuts need to happen in a recessionary environment. When the first rate cut in a cycle is followed by a recession, gold prices have risen by an average of 15.5% after 12 months. If a recession does not follow, they have fallen by an average of 7%. Hence, from a gold market perspective, the question is much more about the outlook for the US economy than the Fed’s reaction to it.

We nevertheless need to acknowledge short-term upside risks from the interest rate outlook, not least as this is propping up the sentiment in the gold market at the moment. The path of least resistance for prices remains upwards, as Western investors seem to have significantly increased their willingness to pay for gold as an economic hedge. That said, in our base case of no US recession, we still see Chinese investors and the People’s Bank of China (PBoC) as the more important medium-to-longer-term drivers of the current record run. This applies particularly to the PBoC, which, in our view, should have an even higher willingness to pay for gold as a geopolitical hedge as opposed to an economic one. We reiterate our Constructive view on gold and have adjusted our 3- and 12-month price targets accordingly to USD 2,600 and USD 2,700 per ounce respectively.

Bitcoin, which is often referred to as digital gold due to its similar supply and demand characteristics, has likewise benefited from expectations of lower interest rates. These expectations have provided some welcome tailwinds for prices, partially offsetting the headwinds of softening demand and a persistent supply overhang. As with gold, we believe that the performance of Bitcoin will also depend on whether or not the US economy slips into recession. However, in contrast to gold, we see a potential US recession as a downside risk for Bitcoin as it does not possess the same safe-haven characteristics as gold as an economic hedge. Why, in that case, is Bitcoin seen as digital gold? Both are non-system assets that should excel as a financial crisis hedge – with the likelihood of such a crisis being very low at the moment.