Mixed messages

Are rate cuts around the corner?

The Bank of England (BoE) signalled a slight dovish pivot at the Monetary Policy Committee’s (MPC’s) February meeting. While the previous meeting stressed that further tightening in monetary policy might be required if inflationary pressures persisted, the February 2024 inflation report made no such reference and added that “the [monetary policy] committee will keep under review for how long Bank Rate should be maintained at its current level”. Despite this, there are clearly major disagreements within the bank about what the future pathway of monetary policy should look like: the MPC was split three ways on its interest rate decision in February with six members backing a freeze in rates, two arguing for an increase and one for a cut. 

Short-term projections for the inflation outlook have certainly improved quite considerably. Indeed, it is expected that UK CPI inflation will hit 2%, the BoE’s target, in just a few months’ time. However, the medium-term outlook continues to pose a problem for rate-setters: a combination of base effects in the energy component of CPI inflation along with projected sticky services inflation mean that CPI will very likely be above target again by year end. Moreover, UK services inflation and, for that matter, nominal wage growth continues to track above counterparts in the Euro Area.

This of course begs the question as to when we should expect rate cuts to come? Nothing in the current growth figures is expected to have a huge influence. There was a minor technical recession in H2 2023 but positive, albeit muted, growth is to be expected in 2024. Other indicators, including those that the BoE is monitoring especially closely (services inflation, private sector wages and labour market tightness), will be far more consequential to decisions made by members of the MPC this year. 

These indicators continue to be giving mixed signals. January’s headline CPI and services inflation print undershot expectations and suggest the disinflation process continues to tick along nicely. Moreover, the inflationary impact arising from conflict in the Middle East remains muted. Shipping costs did see a spike earlier this year but prices have now begun to stabilise and the energy market remains sanguine. However, upside risks to the inflation outlook remain should there be an escalation of conflict and some indicators of domestic inflation remain a worry, not least UK wage numbers that are elevated, exceeded market expectations at the last print, and remain well above levels consistent with meeting 2% inflation in the medium term.

At the beginning of the year, markets priced in a fairly aggressive loosening of monetary policy with predictions of six to seven rate cuts this year. In light of continuing signs of domestically-driven inflationary pressures, we always thought that this was too optimistic and markets have since slashed the number of expected rate cuts. Our view remains that the first rate cut will take place in June this year and that there will be a total of three rates cuts across 2024, in line with current market expectations (as of 16.02).

Daniel Mahoney, UK Economist

Since breaking from the downtrend in rates in January, markets have continued to walk back on expectations for rate cuts over the course of February. The upside bias in rates has been primarily driven by data releases which the market remains extremely sensitive to. I risk sounding like a broken record, but each month’s key data releases on both sides of the Atlantic are the catalyst for the more significant movement in rates – whether that be employment or inflation – which need to be dissected.

To summarise, we have had significant upside surprises in the official numbers for jobs and inflation in the US. Whilst there are always some caveats to consider, the headline numbers could not be ignored by either the market or the Federal Reserve. The change in nonfarm payrolls boasted a 353,000 increase, well ahead of even the highest of economists’ estimates. The increase was not limited to the usual sectors either ie hospitality, health, education and government – it was broad-based. Average hourly earnings also exceeded estimates, rising 0.6% on a monthly basis (4.5% annual). This coupled with inflation (based on CPI estimates) also surprising to the upside, left markets with little choice but to continue readjusting rates higher, as the Federal Reserve will almost certainly delay the first rate cut now until at least the summer. Annual core inflation remained unchanged at 3.9% whereas expectations were for the rate to slow to 3.7%. Housing, airline fares and medical care prices all rose on a monthly basis at a level not seen for a few months, which will be a cause for concern for the Fed.

The Fed meeting at the end of January focused on pushing back on expectations of a cut in March. This was successful, but subsequent data would have done the job for it anyway. As of now markets are just about fully pricing in a first cut in June, with a risk this could be pushed back further to July. For 2024 as a whole the market is now only fully discounting three 25bp reductions (incidentally in line with the central bank’s forecast), down from seven quarter point reductions only a few weeks back. Whilst larger moves have been seen in the short-end of the curve, upward pressure has not evaded the long-end either. The 10-year Treasury yield is back above 4.25%, and many analysts see the potential for a further push higher towards 4.5%.

As for the UK, the data has been a little more mixed. There are still question marks over the quality of the Labour Force Survey employment data, despite some improvements, meaning data on employment growth, and the size of the workforce which influences the unemployment rate should be treated with caution. The inflation numbers did provide the market with some relief coming in slightly below expectations in both the headline and core numbers, remaining unchanged from December’s levels. A big miss in services inflation helped, rising 6.5% on an annual basis in January versus expectations of 6.9%. There was a three way vote split at the February Bank of England meeting, two members again voted to raise rates, whilst one (Swati Dhingra) voted to cut rates, but that was not a huge surprise. Nevertheless it is clear that the BoE is in no rush to cut rates anytime soon, mix this with the relatively resilient data in the UK and rather exceptional data in the US, it’s unsurprising that market rates have drifted higher.

For 2024, like in the US, markets are pricing in 75bps worth of cuts taking Bank Rate to 4.5%, in line with Handelsbanken’s forecast. Looking further ahead on a five year horizon, markets only see further cuts amount to 1%, leaving Bank Rate at 3.5% come 2029. The chart below shows developments in Swap rates (which are effectively an average of these expectations over the period) which shows a c20bp uplift across the curve.

Whilst you could say with hindsight that a good window of opportunity has perhaps closed in recent weeks, Swaps still offer an immediate discount to where Base Rate currently sits. With rates rising and the curve becoming less inverted, this has prompted some conversations around the benefit of longer term hedges. The discount in 10-year Swaps relative to five year is only 10 bps currently, the question is whether the gap is attractive enough to hold the duration risk, compared to hedging at a similar rate over a 5 year period before being able to reset.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg