Why are central banks stalling on rate cuts?

Market recap

• Equity markets finished mixed this week as the economic data and central bank chatter continued to suggest that rate cuts are coming. Soon. Promise.

• The S&P 500 dipped 0.3%, with gains in banks and utilities offset by weakness in technology and consumer discretionary. The TSX outperformed, gaining 0.9% on the back of materials (i.e., gold) and strength in utilities and banks.

• Both the S&P 500 and TSX pushed new 52-week highs this week before dipping on Friday, and both are still running along above their 50- and 200-day moving averages.

Interest rates

Recently, central banks have been sending mixed signals—the Bank of Canada (BoC) is holding interest rates steady despite a weakening economy, the U.S. Federal Reserve (Fed) has said it will hold rates higher for longer but has also indicated that cuts are likely coming this year, the European Central Bank (ECB) is standing firm, and now the Bank of Japan may choose to raise rates. How can we untangle this knot? These contradictions are why we expected more volatility this year—communication is fuzzy and every central bank meeting seems to be a “live” meeting, with no particular outcome preordained. As a result, markets are on edge every time an announcement comes around, with the only near-certainty being that rate hikes from the Fed and BoC are over. But markets are surprised that central banks have been unwilling to give a clearer indication of when we might see rate cuts. The Fed has emphasized that inflation has not yet reached a level where they’re comfortable lowering rates. But the BoC—who many believe should cut before the Fed given the weaker Canadian economy—also hasn’t provided clarity on timing. The chance that inflation could spike back up is North American central banks’ main concern. In our view, however, lowering rates slowly should be fine because consumer perceptions about borrowing costs and inflation won’t change overnight. Also, some of the causes of inflation are out of central banks’ control, and those effects are likely to diminish over time.

Bottom Line: Predictions of a ‘soft landing’ for the economy have largely proven correct—now, central banks should be focused on how to prevent it from becoming something worse.

Consumers

Periodically, it’s worth checking in on the state of the consumer, and right now, we’re seeing a continuation of previous trends. The consumer’s strength is gradually declining—savings and discretionary income are weakening and delinquencies on loans are increasing, which are not ideal signs, but by no means is the consumer in critical condition. People are using their credit cards more and leaning on their debt—they might not be paying off their entire balance each month, for instance. But while some consumer spending patterns have shifted, spending overall has largely continued. On the jobs front, the “quit rate” is coming down, meaning that people are switching jobs less frequently, but the number of open positions remains high. That’s preventing unemployment from picking up, and is further proof that the economy is cooling. Over time, higher interest rates and lower wage increases (the result of inflation coming down) are likely to impact the consumer. But for now, we aren’t seeing anything that worries us too much.

Bottom Line: The consumer is weakening, but not yet weak.

Oil

What’s the latest on oil prices? OPEC continues to make comments about wanting to restrict oil production to a particular level, and while not all members will follow, this at least provides us with some guidance on supply. Our view is that oil is likely approaching fair value—previously, we’ve said that $80-$90 per barrel is the sweet spot, and the price of WTI Crude is currently hovering in the high-$70s range. That doesn’t necessarily mean that oil stocks can’t go up. From what we’ve seen, they appear to be under-invested and earnings seems fairly good, so there is likely still some untapped value in oil-related equities, though perhaps not as much as a year ago. Back then, the dynamics were more favourable—people underestimated supply and overestimated the probability for recession. That’s no longer the case.

Bottom Line: Oil prices are getting close to fair value, and Energy is a sector worth monitoring.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled The American Exception: How U.S. Markets Beat the Bears…Again.