Rate cuts and the ‘Trump trade’

Lower interest rates in Europe are a tailwind for our bond positions

Last week, the European Central Bank (ECB) cut interest rates by 25 basis points (bps) as inflation fell below the 2% target in September and growth remains sluggish. While not pre-committing to more cuts, ECB President Lagarde’s communication hinted that more could be on the way, given growth worries. We expect the ECB to cut rates again in December and eventually bring the deposit rate to 2% by the end of 2025. Because of this, we’ve not changed our increased exposure to short-dated euro-government bonds, as their prices will benefit from falling rates. Last week, bond yields fell across the eurozone, with short-dated bond yields falling more than the long-dated ones. 

Across the Channel, UK inflation also fell below the Bank of England’s (BoE) 2% target. As a result, UK government bond (gilt) yields fell as the market increased its expectations of more rate cuts this year. Markets are now pricing in two consecutive BoE interest rate cuts in 2024, in November and December. We also think more rate cuts are likely. Therefore, we recently increased our exposure to UK gilts in sterling portfolios by reducing our riskier bonds and US Treasury positions. Looking ahead to the UK Autumn Budget (30 October), the expected fiscal belt-tightening could also support gilts further.

Volatility in the US bond market

It’s not just in sterling portfolios where we’ve reduced our exposure to US Treasuries. We’ve done the same across our euro flagship portfolios, as we expect volatility in the US bond market to rise temporarily. While the US Federal Reserve (Fed) looks set to continue cutting interest rates in 2024 and 2025 as inflation falls back to target, we thought the markets’ rate cut expectations were too extreme in September. This played out and, as we own a reduced exposure relative to our long-term allocation, proved to be a tailwind for our performance, as US Treasury yields have risen by around 50 bps and markets have now reduced their expectations of rate cuts by one percentage point. Market expectations are now more aligned with the Fed and with us. 

Could this trend continue as the Fed cuts interest rates? Inflation is near the 2% target and growth is steady, which means the Fed will just bring rates to a more neutral level (from restrictive currently). Therefore, we continue to expect lower US bond yields over the medium term, albeit moderate ones. However, if economic data continue to come in better than expected, as they did last week with retail sales, interest rate volatility could persist.  

US election focus: swinging swing states

There’s another market dynamic at play here with the US election just around the corner. While Kamala Harris still holds a tiny advantage over Donald Trump in national polls, Trump’s now in the lead in the crucial swing states (Nevada, Arizona, Georgia, Pennsylvania, Michigan and Wisconsin). At this juncture, it’s still almost impossible to predict who’s going to win. However, betting and financial markets reflect an increase in Trump’s odds of winning the election, too. While we are cautious about extrapolating too much from this and changing investment strategy according to political headlines, this does point towards an increased likelihood of the Republicans securing the White House and both chambers of Congress, the so-called ‘Red Sweep’. 

Recent market moves are mimicking the reactions they had when Trump won the election in 2016, sometimes referred to as the ‘Trump trade’. Besides bond yields drifting higher on concerns that US government debt might increase faster, equities and the US dollar are also rising, reflecting expectations of stronger economic growth given a potentially large fiscal stimulus. Of course, this could be attributed to better economic data and prospects of further rate cuts. However, the recent rebound in small caps – the Russell 2000 index is up 2% in October vs 1.5% for the S&P 500 – as well as industrial and regional bank equities, combined with the fall in Mexican equities, also suggest that markets see Trump as the most likely winner. Clearly, things could change, and this scenario might not necessarily happen. 

That being said, uncertainty remains high. Gold, an asset that typically does well when uncertainty is running high, remains in an uptrend (+2.2% in October). This is why we still hold the precious metal in portfolios as a long-term diversifier. Gold and other commodities that we hold also benefit from bouts of geopolitical tensions, which continue to dominate headlines. In addition, we recently adjusted, where client knowledge and experience, and regulations permitted, our insurance instruments that aim to cushion the impact of hypothetical equity drawdowns if volatility were to rise further. 

What we’re watching this week:

It’s going to be a relatively quiet week on the economic data release front this week. In Europe, the purchasing managers’ indices for October (Thursday) are expected to show a marginal improvement. However, the composite activity reading (including both manufacturing and services) is still likely to be in contraction territory.  

In September, the Chinese authorities announced several policy measures to revitalise growth, but investors are still waiting to see the details of the fiscal package from Beijing. We could see the fiscal plans this week; however, timelines are not yet confirmed, so it may be November. For now, China has only relied on monetary stimulus, as evidenced by additional rate cuts earlier this week, but it hasn’t been enough to lift growth. In Q3, the Chinese economy grew at the slowest pace since early 2023 and investors are now cautious about the size and implementation of Beijing's fiscal stimulus promises. This caution has resulted in a swift halt in China’s recent equity rally.