Align with Europe? The US? Or take the Bermudan option?

Concerns about persistent inflation pushing back interest rate cut expectations

On 13 April, we learned of the news that Iran had launched hundreds of drones and missiles at Israel in what briefly seemed like the potential start of major regional conflict across the Middle East. The lack of damage caused by the attack and the limited military response from the Israelis meant that the conflict was de-escalated. Markets breathed a collective sigh of relief. Global oil and European gas markets remained sanguine, although the latest tit-for-tat brought to the fore just how disruptive any regional conflict would be. Disruption to shipping in the Strait of Hormuz, for example, would have a huge destablising impact across global markets: 30% of the world’s oil trade and 20% of global LNG trade passes through this area alone.

There is another point worth making, which is that supply shocks arising from geopolitical risk and other factors could occur more frequently and with greater severity over the next twenty years compared to the previous twenty years. Historically policymakers setting monetary policy would “look through” supply shocks when determining interest rates. However, a potential increase in supply shocks could end up having a more material impact on demand-side inflation, which could force central banks into more hawkish positions. 

That said, the aversion of broader regional conflict in the Middle East, for now at least, means that markets are primarily focused on what recent data prints are indicating about the stickiness of inflation. UK CPI y-o-y is down to 3.2% in March and due to base effects will likely hover at around the 2% inflation target for a few months from April. Yet there is still no certainty that inflation will stay at this level in the medium term, not least because the National Living Wage has increased by a near 10%. April’s PMI numbers highlight that this is causing many businesses to see significant pressures on labour costs, and the majority of MPC members will likely want to observe how this ends up affecting wage growth numbers across the economy before backing interest rate cuts. 

Across the Atlantic, data releases are beginning to make markets worry a little about US inflation. US CPI inflation has now overshot market expectations for three months running. This has served to dial back expectations of rate cuts not only in the US but also in the UK and the Euro area. Moreover, the previous narrative that the Federal Reserve would likely be the first of the three central banks to cut rates is not looking by any means certain. US headline inflation is now higher than the UK’s and the gap is due to widen over the next couple of months, leading Governor of the Bank of England Andrew Bailey to indicate the BoE may end up moving earlier than the Fed.

We think there remains sufficient concern about persistent inflation for there certainly to be no moves in UK interest rates at the next two MPC meetings (May and June). We are currently tilted towards the first cut happening in September, with a reasonable chance of it coming earlier in August if the data outperforms market expectations. 

Daniel Mahoney, UK Economist

The big question that has arisen from the movements in April is what the inflation surprises seen (both here and in the US) mean for the UK, and whether market pricing looks correct. To provide an answer to this question we need to consider various elements including the numbers themselves, the recent messaging from the Bank of England and some case studies elsewhere.

Adding fuel to the fire

As ever the US plays a key role in setting the global stage for central bank decisions, and for the UK once again this month has been no exception. After the Federal Reserve meeting last month, markets were feeling relatively confident that the Fed would move to cut rates in June, followed by two more cuts in 2024. February’s job numbers hinted at some cracks which backed up weakness seen in survey data. After the Fed meeting on March 20, markets were pricing in 21 basis points of cuts for the June meeting, or in other terms a c.85% chance of a cut.

Fast forward to now and the market pricing is unrecognisable, with now just one 0.25% cut now full priced in for 2024, with that cut now coming in Q4 rather than the summer. Sandwiched between the last Fed meeting and now there has been another red-hot jobs report for March, where nonfarm payrolls grew by 303,000. But more importantly we had further inflation reports printing higher than expected figures. The one in the spotlight being the March 0.4% month-on-month increase in core CPI and PCE, driven by services excluding energy and housing.

Post-inflation, not only did we see the markets discount to just one cut in the US this year, but we also saw longer-term bond yields and swap rates rise across the curve. The US 10-year Treasury yield had risen back above 4.5%, prompting some calls for the 5% mark again. UK markets followed suit, with swap rates similarly up across the curve, taking the 5-year swap back above 4% – whilst for 2024 we have seen some pullback in rate cut expectations. Momentum for higher rates accelerated further following the sticky wage growth numbers in February, as well as the UK’s own inflation surprise in March – led by services inflation again. A cut in June now also appears a write-off, with focus switching to the August meeting. Markets are now also only fully pricing-in one cut for 2024.

Were markets right to react how they did?

It is normal to see increased volatility when you get surprises in key data. Some may argue though that the difference in the actual figures relative to expectations were only minor, a 0.1% discrepancy, even less with rounding. That in isolation may suggest some overreaction, as well as the fact it is only one month’s data, but wider context is important. Over the Atlantic, hard US data remains strong, from the labour market to retail sales, therefore momentum in markets around delayed action from the Fed was already building prior. The inflation surprise was also not driven by the usual suspects like housing or autos so was going to raise some eyebrows. Overall given that June is not far away, the Fed has ran out of time to justify a June hike from released data, probably July too. September cannot be ruled out for a cut, but hard data will need to start turning soon to allow those at the Fed to get comfortable with the idea. What is clear is that any summer move is now a no-go.

Some may suggest the picture for the UK however is a little more clouded given some prior dovish messaging from the Bank of England, whilst other central banks flexing independence from the Fed is also a consideration.

Embracing divergence

Despite the change in the US path, we have seen both the European Central Bank (ECB) and Bank of Canada (BoC) in their April meetings open the door to a cut in June, indicating that they will move independently of the Fed if they feel is necessary. Neither pre-committed to a June hike, but it looks a done deal in the former, while the BoC governor Tiff Macklem mentioned a June cut is “in the realm of possibilities”. It is worth noting however that the inflation story is milder in both Europe and Canada relative to the UK, with annual core inflation at around 3% in both relative to 4.2% in the UK, therefore there is a better argument for a pivot away from the Fed. 

The BoE may look to these meetings as a blueprint for its communication at the May meeting if the view within the committee majority is that it wants to cut rates imminently. The contained market reaction to both meetings should be viewed as a success. 

Risks to the outlook for rates cuts beyond the summer are evident though, stemming from higher commodity prices as well as currency weakness, which are inflationary. As illustrated earlier in the article the rises in oil and gas prices have not escalated further, but will be monitored. We have already seen signs within the ECB that the outlook beyond June is rather unclear.

Will the BoE diverge?

The simple answer should be that the data should do the talking, and given the upward surprise in inflation for March, markets (after some wobbles) have priced the view the BoE will delay a rate cut too. Chances of a June cut are now priced at 30%. Those clinging onto a June cut will point to recent comments from Governor Andrew Bailey who provided some clear hints that some within the MPC, including himself were encouraged by recent data on inflation. In his interview with the Financial Times he also welcomed the fact that markets were pricing in rate cuts for this year, and that inflation does not need to be at 2% to cut rates. At an event held by the IMF in Washington, Mr Bailey noted that the dynamics in inflation between the US and Europe are different – with inflation in the US being more demand led. This was backed up by another internal MPC member, Dave Ramsden, who noted downside risks to domestic inflation.

However comments from MPC member Megan Greene seem to contradict those of Andrew Bailey’s, suggesting she is wary of moving before the Fed. Ms Greene argued against the view that we should cut before and by more than the US given the threat of inflation persistence is greater in the UK. Her argument suggests that market pricing has perhaps not reacted enough. Ms Greene sits at the hawkish end of the spectrum alongside Jonathan Haskel and Catherine Mann, and it’s safe to say they were not going to be voting to cut rates at the June meeting regardless of April’s events. 

The focus will turn to the other six members, where only five need to vote for a cut to have a majority. Based on recent comments alone, to us it suggests Chief Economist Huw Pill will join the hawkish trio in voting for no change, whilst Andrew Bailey and Dave Ramsden could potentially join Swati Dhingra in voting for a cut. 

On that assumption it may be an extremely close call, but we may be thinking too much into it at this stage – it is entirely plausible we see extremes of a 5-4 split either way or a 8-1 landslide in favour of hold. The communication at the May BoE meeting will be critical.

The Bermudan option

To summarise, the market reaction as a whole seems rather fair. Q4 seems a sensible starting point for the Fed now with the summer meetings coming up fast. Naturally movements in the US will lead to some adjustments elsewhere, and will be a consideration to all other central banks. But history shows that divergences between major central banks are also normal, in fact this movement in lockstep we have seen in the past two years is rather unprecedented. Therefore if the BoE majority feels cutting rates in June is the right decision, the bank will move independently of the Fed and the market view. 

Whilst we acknowledge the risks of a June cut, we don’t think the data is there yet, therefore taking the “Bermudan” option (the middle ground) to cut between Europe and the US in August or September does seem sensible - an August cut allows the MPC to support its judgement via updated forecasts too, or at least set the scene for a cut the following month.

Cameron Willard, Capital Markets

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