Key Takeaways
- Central bankers have been pushing back on expectations around early interest rate cuts. But what about longer-term?
- US inflation should continue to fall over the coming months and slowing wage inflation would allow the Federal Reserve to declare victory and cut rates heavily over the next 12-months.
- Europe’s economic backdrop remains uncertain, and the European Central Bank will wait for data to support a discussion on cutting rates. Here, we are likely looking at mid-year.
- With a looming rise in the minimum wage and an upcoming pre-Election Budget, the Bank of England looks set to adopt a wait and see approach and will likely be one of the last to cut rates.
Market expectations for early interest rate cuts have received one setback after another since the New Year. Central bankers in the US, UK and Eurozone have consistently pushed back on market expectations of early cuts in their official rates. This became even more specific with comments last week from the head of the US central bank after their rate-setting meeting that a cut in March was ‘not the base case’. This was followed a few days later by super strong US labour market data.
The result has been a sharp rise in interest rate expectations. This is especially evident and especially relevant in the UK where 2- and 5-year SWAP rates, which drive mortgage rates, have risen by 50 and 40 basis points respectively since their lows just before Christmas. To be fair, as you can see from the chart, they had fallen by much larger amounts since their peak last July. Nonetheless, some lenders are likely to withdraw low mortgage rate deals that they have recently unveiled while deposit takers will be looking to improve the rates on their fixed rate bonds.
UK interest rate swap sharply in 2024
Source: Columbia Threadneedle Investments, Bloomberg and Macrobond as of 05/02/2024
What does all this mean for the longer-term outlook for interest rates and financial markets more generally?
It seems to me that we are still in for big cuts in interest rates in developed world but that the outlook is clouded by economic uncertainty. In the case of the all-important US Federal Reserve, politics has also come into play. Donald Trump has been fiercely critical of the chair, Jay Powell and accused him a few days ago of planning to cut interest rates to help Biden get re-elected. Jay Powell has taken the unusual step of going on US national television to set out his plan for cutting interest rates and stated that a cut in March was possible but not the base case. He also said that they were focussing on the year-on-year inflation rate, rather than the 6-month annualised rate that had been previously emphasised. This is a good move, some prices for example used cars and car rentals, have fallen by 20% or more over relatively short periods. Those falls will not be repeated, yet a 6-month annualised measure risks double counting.
The good news is that year over year inflation should continue to fall over the next few months due in large part to favourable base effects: significant price rises at the start of 2023 will drop out of the year on year comparison especially over the next two months. Slowing wage inflation should allow the Fed on declare victory with a sustained move to their 2% target and cut interest rates heavily over the next year.
Over in Europe and the UK, there is less political pressure but much more economic uncertainty. Madame Lagarde said that she was ‘data not date’ dependent and that is ‘premature’ to discuss rate cuts. They need to see a big slowdown in the wage round currently underway and continued progress on inflation if they are to cut in April. That’s a possibility but, with no meeting in May, the next bet in June.
The Bank of England is firmly in the ‘wait and see’ camp. They know that a 10% hike in the minimum wage is coming and understand that the government are considering a giveaway budget in March. They too need to see a big fall in UK wage inflation, and I think they will be one the last central banks to cut rates.
All in all, falling inflation and falling interest rates are good news for financial markets overall. The problem is that there is a great deal of optimism already priced in and central bankers are cautious beasts.
