We will do a deep dive into how to trade the upcoming US Federal Reserve meeting on Wednesday but for now we need to address the Fed and others from an Australian traders perspective as it is one of 3 plays we need to be mindful of.

1. Hard or Soft – Can we stick the landing?

All central banks across the developed world are doing summersaults, with a one and half twist to land their respective economies with a soft landing. And this is increasingly seeing them align towards coordinated easing – barring the RBA more on that later.

The debate between soft and hard landings in the global economy is accelerating. For example, traders have begun to notice that there is a switch in trade from the previously held trade of bad economic data that was often seen as good for risk assets, as it increased the likelihood of monetary easing. To the now, poor data is also being traded as negative for risk, reflecting growing fears that economic weakness could be deeper and more prolonged than anticipated. We have highlighted this point through the US employment data and the slowing numbers in GDP.

Equity markets clearly believe they will stick the landing with record all -time high trading in the DOW, S&P and most other major bourses including the ASX 200. But they have yet to fully account for the potential downside risks of a hard landing scenario. In fact, equities have a bigger divergence that could spell trouble if central banks get it wrong as it is really only a small group of high-performing sectors or stocks that are driving gains, while many others lag. This narrow leadership, combined with elevated valuations, raises concerns about the market’s vulnerability should the hard landing scenario materialise.

This brings us to Thursday’s Federal Reserve meeting – it will cut the expectations for a 25-basis point cut at the upcoming September meeting sits at 42 percent the bigger 50-basis point cut sits at 62 per cent. This has led to increased debate around market positioning and sector rotation. The Fed’s recent communications have largely endorsed the beginning of an easing cycle at a slow pace. But that hasn’t stopped traders putting in an upward repricing – the bull steepening of the yield curve, particularly led by short-term yields, as markets anticipate rate cuts. 

This steepening trend, which began in earnest in late June, is significant because it reflects a growing belief that the most acute phase of the economic slowdown, and the associated recession risk, may be over.

Take the US 2-year and 10-year yield curve which has been inverted. Traditionally, an inverted yield curve signals a looming recession, but the recent return to a more normal curve suggests that the period of waiting for a slowdown and/or recession may have passed, and markets are now pricing in the economic consequences of monetary easing. Historically, during periods of bull steepening, certain defensive sectors such as Healthcare, Utilities, Banks, and Staples have outperformed, as investors shift towards sectors that offer stability and reliability in times of economic uncertainty, but that hasn’t happened – suggesting a gap is forming.

Looking closer to home –  the typical sectoral performance associated with yield curve steepening has only partially played out. Just have a look at the Tech sector, it has significantly outperformed this year, a divergence from its usual underperformance during such periods. This divergence is largely due to the impressive growth execution couple that with their larger capitalisations in this cycle has made them a substitute for the quality growth traditionally offered by Healthcare.

Looking forward, should the yield curve move from bull steepening to bull flattening (where the long end of the curve leads the decline), leading sectors are expected to shift. 

In a bull flattening trade, sectors such as Real Estate and Materials typically emerge as leaders, creating the potential for broader equity market gains. This scenario is currently the most plausible case for broadening equity returns and driving further upside in the market index. 

2. Commodities: Mind the thud

While financial markets are pricing in the possibility of a soft landing, commodity markets are facing a much more severe test of the hard landing so hard it might be considered a ‘thud’.

The cost curves for key Aussie commodities, such as Iron Ore and Metallurgical Coal, are being battered by soft global demand and oversupply dynamics particularly out of China. These cost curves are being tested as commodity prices struggle to find support amid concerns over an economic slowdown. This is certainly the scenario BHP and Rio are seeing and have factored this into their forward guidance numbers.

Then we look at global commodities – oil inventories have reached levels typically associated with recessions, further signalling the market’s concern over weakening demand and OPEC’s recent communiques suggesting it will halt its planned increases in output.

We also have a scenario not seen in the modern era, a China story that isn’t working. China’s economic policies are under intense scrutiny, and the country’s growth trajectory will significantly impact global demand for key commodities in the coming year. The negative price signals in the commodities space stand in sharp contrast to the more optimistic outlook being priced into equity markets. 

While equities suggest a soft landing is still the base case, commodities are flashing red with alarm as price weakness implying deeper demand concerns and thus issues around growth. 

This divergence raises the risk of a sharper reversal in positioning, particularly in resource-linked equities. The caveat to this is the ongoing capital constraints on supply, combined with the potential easing of demand concerns as monetary policy softens, could set the stage for a recovery in certain commodity markets. 

If this was to play out, broad exposure to large-cap Energy stocks, particularly in Oil and Uranium, as well as to large-cap diversified Materials and Gold could be beneficial , as these sectors are well-positioned to benefit from any eventual recovery in global demand.

3. RBA’s Easing Path – When not If

The Reserve Bank of Australia (RBA) continues to chart its own path. It’s cautious approach that prioritises inflation risks has been the core principle of RBA Governor Michele Bullock. And despite mounting expectations for a faster easing cycle, the RBA has so far resisted pressure to cut rates aggressively stating that controlling inflation is far more important than short term growth concerns.

Investors are divided on how quickly the RBA will move to ease policy. While the central bank has maintained a patient stance, market expectations are pricing in a full rate cut by February. The consensus view is that the RBA will ultimately follow the lead of other central banks and cut rates sooner than currently forecast, with some expecting the easing cycle to begin well before the RBA’s projected May 2025 timeline. But whenever it starts – all are of the same view, once they start it will signal a solid period of cuts. The consensus is that come December 2025 – the cash rate will be 3 percent not the current 4.35 per cent we have.

The RBA’s decision-making will come down to the economic landing all are facing. Should a hard landing materialise, the RBA may be forced to cut rates faster to support the domestic economy. However, if a soft landing prevails, there is every incentive for the RBA to remain behind its global peers in cutting rates. This approach (which is the current one taken by the RBA) would help support the AUD. It would also help in reducing the inflationary pressures from imported goods, while also allowing the labour market to cool and consumption to weaken, preventing a rapid reacceleration of inflation once policy is eased.

For equity markets, the RBA’s cautious easing profile suggests a prolonged period of below-trend growth. This would delay the cyclical uplift in earnings that is needed to justify current market valuations. 

As a result, it can explain why the ASX keeps hitting resistance at around 8100 points, there is no catalyst to push it higher. While the easing cycle will eventually provide a tailwind for equity valuations, the current environment of slow growth and cautious monetary policy implies that significant market gains are unlikely until later in the cycle.

 

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