Key Takeaways
- Interest rates in the US, UK and Europe are on a general downward trajectory, but I don’t necessarily follow the consensus on what happens next
- In the US there’s a picture of a gentle decline in inflation, despite Trump’s tariff uncertainty. Looking further out I think the consensus is underestimating future Fed cuts
- Could the UK be ushering in a period of stagflation – rising inflation and low/no growth? We agree with the Bank that inflation will eventually fall but I don’t think it should keep cutting
- Europe is looking more settled, and the consensus is for more cuts, but I’m not sure I agree to what extent
- All in all, although lower rates are good for risk assets, is this really a good time to be taking large positions?
The past two weeks have seen monetary policy meetings for the big four central banks in the developed world. In this week’s Market Perspectives we take a look at where markets think interest rates will be going over the rest of the year, and where we differ on that outlook.
We need to start with the US. The new president, Donald Trump, has certainly stirred things up with a frenetic stream of policy announcements, but we see the macro outlook as reasonably settled. Growth is steady at a goldilocks pace – strong enough to keep the economy well clear of recession but not so strong to push inflation higher. Indeed, we think inflation will continue to gradually improve. This week’s CPI release will provide an update and markets will react strongly to any surprise, but the bigger picture is of a gentle decline in US inflation back towards the 2% target. Both rent and wage inflation are slowing – and they are the most powerful drivers beyond the month-to-month fluctuations.
But how can you say that, I hear, when we’ve just had figures in the closely watched payroll report showing a rise in average hourly earnings? Well, I suggest you ignore those figures, which are distorted by compositional effects – in this case a shorter working week due to fires in Los Angeles and bad weather elsewhere, which mathematically raised the average per hour. And we are not worried about tariffs either: even if Trump imposes the most comprehensive tariffs, they won’t apply to all imports, which are a small share of GDP and an even smaller share of consumer spending. The market expects just 38bps of cuts from the Fed by year-end; we think the number will be closer 100bps. That would still leave rates above neutral.
In the UK, the Bank of England last week cut rates by 25bps. This was widely anticipated but the market reaction initially was dovish, because two members voted for a bigger cut and no one voted to keep rates on hold. We would discount the two dissenters and note that the BoE raised its near-term forecast for inflation significantly, despite also cutting the forecast for growth. Stagflation indeed. Hopes that Rachel Reeves’ first budget would boost growth in the near term have been dashed. We agree with the BoE’s outlook: eventually the weak economy will push inflation back down, but this will take time. The market expects the next cut in May with 62bps in total for the rest of the year. We think the next few months will be distinctly unsettled for the UK and believe the BoE should keep rates on hold. It may be late this year or into 2026 before we get more significant cuts, but by then rates should have fallen below general market expectations.
The outlook in the Eurozone looks more settled. That’s certainly what the market thinks, with a consensus that the European Central Bank will definitely deliver another 25bps cut at the next meeting in March. The market also sees a total of 88bps in cuts over the rest of the year. That would take the rate down to just 1.8%. That is undoubtedly possible, but I reckon the chances are we might see fewer cuts.
Meanwhile, the Bank of Japan bucked the trend with a rate rise at their recent meeting, with the prospect of more increases to come as they emerge from the lost decades of deflation.
So what does all this mean for markets? Leaving Japan aside, interest rates are falling, which is good for risk assets. But all the uncertainty and genuine damage from Trump’s tariffs goes the other way. In terms of asset allocation, we don’t think this is the time to take large positions. We are modestly overweight equities and generally neutral elsewhere.
