False Start! Markets Jump the Gun On Rate Cut Timing and Magnitude

Exclusive insight for TMI subscribers! Northern Trust Asset Management share a monthly market commentary for treasurers.

Eurozone Market Update

As widely expected, the ECB kept its key interest rates unchanged in December, maintaining the deposit facility rate at 4%. The accompanying press release acknowledged the recent fall in inflation, replacing previous commentary on inflation being “too high for too long”. The statement also noted “domestic price pressures remain elevated, primarily owing to strong growth in unit labour costs,” reflecting that wage inflation has the ECB’s attention. One hawkish surprise was a change to the ECB’s pandemic emergency purchase program (PEPP), with reductions to the PEPP portfolio of €7.5 billion per month on average, starting in the second half of 2024. There were no changes to the plan to discontinue reinvestments at the end of 2024. New ECB staff economic forecasts indicated a slower path for growth in 2023 and 2024 and suggested that the risk to growth remains on the downside.

_{Source: Bloomberg, data as of 29 December 2023}

UK Market Update

In December, the BoE kept the bank rate at 5.25%, but the split in Monetary Policy Committee (MPC) voting highlighted the Committee’s more hawkish skew relative to other central banks. While six of the nine members supported a continued pause, three voted for an increase of 25 basis points (bps). The MPC reiterated that while consumer price inflation has fallen as expected and private sector wage growth surprised on the downside, critical indicators of persistent UK inflation remained elevated. The Committee also reminded market participants that “relative to developments in the United States and the euro area, measures of wage inflation were considerably higher in the United Kingdom and services price inflation had fallen back by less so far.” They noted that monetary policy is likely to remain restrictive for an extended period and may even have to become more restrictive if there is evidence of more persistent inflationary pressures.

_{Source: Bloomberg, data as of 29 December 2023}

US Market Update

The Federal Open Market Committee (FOMC) left the target range for the Federal Funds Rate unchanged at 5.25-5.5% in December, as widely expected. The accompanying statement was slightly altered, to note that “inflation has eased over the past year but remains elevated.” However, the tone from Fed Chair Jerome Powell was significantly more dovish, affirming the market’s recent expectations of rate cuts and driving yields sharply lower. Market reaction seemed driven by the revised Summary of Economic Projections (SEP), where not a single participant expects an additional hike in 2024 and the median participant expects the equivalent of three 25 bps cuts by the end of the year, one more than in the previous SEP. The Personal Consumption Expenditure (PCE) price index (the Fed’s preferred inflation gauge) was down 0.1% in November, while the monthly core index was up 0.1%. The annual PCE reading softened to 2.6% from 3.0%.

_{Source: Bloomberg, data as of 29 December 2023}

Looking Ahead

Entering 2024, attention turns to the timing of when all three central banks will feel confident to start cutting interest rates. In the US, market pricing as of mid-December suggests that a first cut is highly likely as soon as March, but we see a much more gradual transition from “how high to hike” to “when to cut” taking place. We believe the FOMC will want greater confidence that inflation is on a downward trajectory to 2% before it starts cutting rates. As we expect inflation only to be coming down gradually in the coming months, we think it will take some time for the FOMC to feel sufficiently confident to cut rates, especially if the labor market is slow to cool off. We see a first cut early in the second half of 2024 as more likely than in either March or May.

In the euro area, we expect the ECB to remain vigilant in preventing a resurgence of core inflation. Wage inflation will be a crucial data point for them, and we anticipate they will keep rates at an elevated level until mid-2024, before embarking on a steady pace of rate cuts. Current market pricing suggests a first ECB rate cut in June, with over 150 bps of cuts priced in for the year. We agree that the timing of the first cut makes sense, but note that data will govern the timing and magnitude of cuts for 2024.

In the UK, data points to a stickier inflation dynamic and suggests that monetary policy normalization is likely to come later than in the euro area or the US. Our view is for a “Table Mountain” profile, where the bank rate remains at the current level for a prolonged period. The timing of cuts remains highly uncertain, reflecting a range of unresolved questions that include the extent to which excess household savings have been spent down, the effects on consumption of coming mortgage renewals, and the economic impact of upcoming elections. The UK’s inflation woes have been exacerbated by idiosyncratic labour issues, including a Brexit-induced shrinkage of the workforce and a still-high proportion of potential workers classified as “long-term sick” in the aftermath of the pandemic. The lagged effects of monetary policy will likely be more impactful in 2024, particularly in light of coming mortgage rate resets. We believe the current market pricing of rate cuts starting in March 2024 is premature, with the second half of 2024 a more likely timeframe.

Chart of the Month

_{Source: Bloomberg as of 31 December 2023}

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