Key Takeaways
- Interest rate cuts are widely anticipated but there has been little discussion around where they’ll eventually end up.
- The median number for the Federal Reserve’s ‘dot plot’ for the Federal Funds rate is 2.5%. Markets are pricing in 3.5% long term.
- In contrast, the Federal Reserve continues to push back against expectations for significant cuts in the near term.
- Longer term in Europe and the UK, interest rate futures put the terminal rate at 2 and 4% respectively. In our view the former seems too low and the latter too high.
- In the week ahead, inflation looks set to be a key determinant of market direction.
Markets have been playing a guessing game over when the major central banks will begin to cut rates and how far they will fall in the year ahead. There has been far less discussion about where they will end up, the so-called terminal rate debate. Yet this is a critical decision for long term investment plans, directly affecting the outlook for bonds and indirectly affecting equities.
The US Federal Reserve gives us a clear idea of their thinking around this issue with the longer term ‘dot plot’ for the Federal Funds rate. The median number is 2.5%. By contrast, market pricing for US interest rates in the longer term shows much higher values. For example, the futures market for Federal Funds rate troughs out at 3.5% in the longer term, a full percentage point above the ‘official’ estimate. Part of the difference relates to the median versus the mean for the dot plot: the average of projections above the median exceeds that for those below. But a wide gap remains. Moreover, when it comes to the near term, the pattern is reversed: the Fed have consistently pushed back on market pricing for cuts that are earlier and bigger in 2024.
There is an old market saying ‘don’t fight the Fed’. In this context the advice would be patience in the near term but optimism in the longer term. If the Fed are right about the ultimate destination for Federal Funds rate, bonds would be attractive, and equities would be supported.
What about interest rates in the UK and Europe? Interest rate futures point to a terminal rate a little over 2% for the eurozone and getting on for 4% in the UK. The former seems too low and the latter too high to us. Consider for example the chances of reality differing by 1 percentage point from these numbers. 1% looks implausibly low in the Eurozone, 3% quite possible. With a 2% inflation target, sustained UK interest rates of 5% in the UK are unlikely, 3% a distinctly possible.
This would suggest to us that longer term bonds are more attractive in the UK than in Europe, for example.
The week ahead will see crucial inflation data in the UK and US coupled with other important data that will affect central bank decisions. This will inevitably dominate the markets’ focus this week. Yet the longer-term interest rate outlook will be less affected and is, in our opinion, a more powerful influence.
