Global Central Banks Cut Rates as Federal Reserve Maintains Position - Market Reactions and Political Risks in Emerging Markets

Key Takeaway

• Central banks in Sweden, Switzerland, Canada, and the eurozone have cut rates this year, leading to manageable currency depreciation.
• The Federal Reserve maintains its rate range of 5.25%-5.5%, with markets anticipating up to two cuts by year-end.
• Emerging markets face political risks; Mexico's bond yields surged post-election, while India's stock market recovered despite Modi's party losing its majority.

Central Banks Cut Rates

Central banks in several developed markets have begun cutting interest rates ahead of the Federal Reserve, a move that has not been as detrimental as initially feared. Sweden, Switzerland, Canada, and the eurozone have all reduced rates at least once this year. This preemptive easing has led to some depreciation in local currencies, but the impact has been manageable. For instance, the euro has shown resilience despite the European Central Bank's (ECB) recent rate cut and a hawkish outlook. Emmanuel Macron's decision to call a snap election in France added to the market's unease, but the overall currency performance has been relatively stable.

The global trend is towards lower rates, albeit slowly. A diffusion index tracking rate changes across 57 central banks shows a cautious descent. The index assigns a value of +1 for a rate hike and -1 for a cut, indicating a general move towards easing. Argentina and Venezuela, grappling with severe inflation, are at the extremes of this trend, having made significant policy adjustments.

Fed's Position and Market Reactions

The Federal Reserve has maintained its policy rate range of 5.25% to 5.5%, with no immediate plans to cut rates. Recent US economic data has been inconclusive, complicating the timing and extent of future rate cuts. Fed Chairman Jay Powell has remained dovish, despite strong first-quarter data. Bloomberg Economics suggests that the labor market has already cooled, and final payroll data revisions may reveal a higher unemployment rate than currently reported.

The Fed's upcoming dot plot, which outlines future rate expectations, will be closely watched. As of March, the median forecast indicated three cuts by the end of the year, but this may be revised. The market is currently pricing in slightly less than two cuts by year-end. Kevin Flanagan, head of fixed income strategy at WisdomTree, noted, "Maybe we get one or two cuts this year, but how many are we going to get next year?"

Emerging Markets and Political Risks

Emerging markets, having acted against inflation earlier, are further along in the easing process. However, this carries risks, as seen in recent elections in Mexico and India. In Mexico, Claudia Sheinbaum's Morena party fell short of a Senate supermajority, causing market jitters. The spread of Mexican 30-year bond yields over US Treasuries surged to an 18-month high. Carlos Capistran, a Mexican economist at Bank of America Corp., explained, "A qualified majority in Congress substantially increases policy risks as it could provide a window in which market-unfriendly reforms could be approved."

India's stock market initially reacted negatively to Prime Minister Narendra Modi's party losing its majority but has since recovered. Investors are cautiously optimistic, as Modi remains in power, albeit with limited freedom of action. South Africa is also navigating political uncertainty, with the African National Congress negotiating a coalition government for the first time.

Street Views

• Carlos Capistran, Bank of America Corp. (Bearish on Mexico's political risk):

  "A qualified majority in Congress substantially increases policy risks as it could provide a window in which market-unfriendly reforms — currently in Congress — could be approved, as AMLO’s term overlaps with the new Congress in September. Once Sheinbaum takes office, the risk will likely continue. Some of those reforms could imply a wider fiscal stance."