Navigating diverging monetary policies

Last week, the US Federal Reserve (Fed) cut interest rates to the 4.00–4.25% range. It’s the first cut since December 2024. Why now? Even though inflation is above target, the labour market is showing signs of strain and job growth has been revised down.  

Fed Chair Powell called it a “risk management” move. In plain terms, the Fed is trying to get ahead of a potential economic slowdown before it becomes a problem. It is trying to strike a balance between containing inflation and protecting the labour market. 

The Fed’s updated projections show most policymakers expect two more rate cuts, bringing rates to 3.50-3.75% by year-end. They see inflation easing slightly, but still above target, and unemployment going up. Markets had anticipated the Fed’s decision, but there’s a risk that investors are getting ahead of themselves. If inflation proves sticky or the labour market weakens faster than expected, the Fed could easily change course. Bottom line: policy is still data-dependent, and the balance is fragile. 

The cut was broadly positive for our portfolios. We’re overweight equities, which welcomed the rate cut. Lower rates support earnings, reduce discount rates, and add fuel to the AI-driven rally. We’ve also reduced our dollar exposure this year as we think the currency has room to weaken. This played out following the cut with the USD depreciating. Lower US rates also narrow the interest rate gap with other regions, which gives room for the euro, pound and yen to strengthen. 

Bond yields also fell slightly. We prefer European bonds (and gilts in sterling portfolios) over their US counterparts, where high deficits and inflation risks are still in play. Inflation-linked bonds and commodities also remain in our portfolio mix as protection against any persistent inflation. We hold an overweight in gold, too, which benefits from lower interest rates and acts as a hedge against geopolitical shocks and growth uncertainty.  

The Bank of England (BoE) held rates steady last week. Inflation is still nearly double the 2% target, so they’re not ready to ease further. Growth is weakening, but inflation isn’t falling fast enough. However, there was a shift in policy from the BoE. The central bank announced it is scaling back its bond sales, the so-called quantitative tightening (QT), from £100bn to £70bn a year. That’s likely a tailwind for markets as there will be a smaller gilt supply. It will also mean a smaller hit to the Treasury’s budget covering the loss of the BoE, which has been selling bonds after yields rose. Looking ahead, sticky inflation means UK rates are likely to remain at 4% throughout 2025. But with the labour market weakening, we expect inflation to fall in 2026, opening the door to rate cuts. As gilt yields have risen when US ones have fallen, gilts are attractive from a valuation perspective. With rate cuts on the horizon, a slower pace of QT, and austerity prospects, we are overweight gilts in sterling portfolios. 

In Japan, the central bank is still holding the line on easy policy. But things are shifting. Wages are rising, inflation is creeping up, and expectations are building for another rate increase later this year. If that happens, it will mark a clear divergence from the Fed and could push the yen higher. 

Lastly, the Norwegian central bank, Norges Bank, cut rates to 4% from 4.25% even though inflation is still above the 2% target. Looking ahead, the central bank sees a gradual decline of its key policy rate over the next couple of years (to roughly 3%). 

The release of purchasing mangers’ indices (PMIs) kicks off the week across the Eurozone, UK and US (Tuesday). These will give the first read on September activity. Germany and the broader Eurozone are expected to show signs of life, maybe even a move into expansion. Central banks in Sweden (Tuesday) and Switzerland (Thursday) are likely to keep interest rates unchanged. 

In the US, Friday’s core personal consumption expenditures index – the Fed’s preferred inflation gauge – will be released alongside consumer sentiment data. This would help shape expectations of how many more rate cuts the Fed could make by year-end. 

Japan’s inflation data (Friday) and PMIs will also be key. They’ll help clarify whether the Bank of Japan is ready to shift gears.