The Federal Reserve delivers an early Christmas surprise

December 2023

The economist's corner

Markets are pricing in that base rate has peaked in the UK and that we should expect six interest rate cuts in 2024. At its December meeting the Bank of England (BoE) held rates at 5.25%, as expected, and this is indeed likely the peak of interest rates in this cycle. However, three members of the Monetary Policy Committee (MPC) went against the majority and backed a 0.25% hike in rates and the BoE has tried to push back against current market expectations for interest rates next year. 

Even a majority of those MPC members supporting rates being maintained at 5.25% have expressed a view that it is too early to conclude that services inflation and pay growth are on a downward path, highlighting broader unease across the committee that domestically-driven inflation may not yet be completely under control in the UK. While we think that cuts to interest rates will likely begin in June next year, we are of the view that remaining tightness in the labour market will mean the drop in base rate will be at a slower pace than current market expectations. 

Daniel Mahoney, UK Economist

A view from the dealing desk

It has been a rather chaotic end to the year for markets to say the least, characterised by markets pushing for substantial rate cuts across the developed world next year and central banks either pushing back or endorsing those expectations. We saw a hawkish surprise in Norway where the benchmark rate was lifted unexpectedly to 4.5% (due to a weak currency), whilst the Bank of England and the European Central Bank stuck to script. It was the Federal Reserve which caused the major surprise, providing even more momentum to those looking for substantial rate cuts next year.

As Dan mentioned above, we expected a hawkish decision from the Bank of England to push back against market pricing for cuts in 2024. Comments from Governor Bailey prior to the meeting already hinted that the MPC was uncomfortable with market pricing. Three members still voting for a hike was bold, but not unsurprising either. Long-term swap rates jumped around 0.1% after the decision, but that is overshadowed by the drop in rates seen in the morning following the Federal Reserve meeting. Not only that, the following week saw another sharp drop in both headline and core inflation, both lower than consensus and the MPC forecasts. The decline was broad based too, with a notable decline in services inflation. Naturally rates dropped even further, Swap rates longer than two years are all now trading below the 4% mark. For 2024, six 25bp cuts are now priced in.

The aforementioned Federal Reserve meeting was the real surprise. As the BoE did, most expected some minor pushback from the Fed in order to ensure market pricing was not loosening extensively, undoing the work to tighten policy in the first place. But instead we saw the opposite. The supporting statement and comments from chairman Jay Powell effectively confirmed that rates are at their peak, and that the Fed is cautious about keeping policy tight for too long. The Fed also acknowledged that growth has slowed and inflation has eased. Overall the Fed now expects 75bps of cuts next year, whilst also removing the additional hike it has had in the dot plots this year.

As perplexing as the comments were, endorsing the market view ignited a further rally in rates in both the short and long-term. The 10-year Treasury yield is now below 3.9% and momentum suggests it could move lower, whilst for 2024, 125-150bps of cuts have been discounted. Data has been holding up of late, which makes the Fed strategy even more confusing (unless it knows something we don’t in underlying data), but for the Fed to cut rates in March as expected we will need to see a slowdown in January’s inflation and labour market numbers.

Cameron Willard, Capital Markets 

Due to the Christmas holidays, December’s Rate Wrap is a shortened summary of the month’s economic and market events. Our normal articles will resume in January where we will detail our outlook for 2024.

We hope you have a wonderful Christmas!