Dust starting to settle after a bumper month for markets

UK: Chancellor’s fiscal targets could be at risk

• The Office for Budget Responsibility forecasts that Chancellor Rachel Reeves has a 54% chance of meeting her fiscal target.
• Since then, government borrowing costs have increased, Bank of England forecasts highlight a more downbeat view of the UK economy, and the risk of tariffs providing a downside risk to growth.
• Supply-side reforms on financial services and planning could provide a boost to the productive potential of the economy, albeit in the longer term. 

It was some weeks ago now and has, of course, been somewhat overshadowed by events across the Atlantic, but it is worth taking a moment to reflect on the new government’s first Budget. This marked a significant pivot in UK fiscal policy: taxes were hiked by a total of around £40bn with spending rising by roughly £70bn, making this a notably fiscally expansionary financial statement. Part of the spending increase is accounted for by a boost to capital expenditure, which has led the OBR to upgrade the potential long-run growth rate of the economy, but other metrics suggest a worsening macro outlook. For example, medium-term growth forecasts by the OBR have seen a notable revision downwards since March and inflation will rise by 0.4pp at the peak as a direct result of this Budget. 

This spells potential trouble for Chancellor Rachel Reeves. First, the UK inflation dragon has not been slayed yet given that UK CPI is expected to end the year closer to 3% than 2%. The inflationary impulse from the Budget increases the risk of inflation persistence. Second, the OBR forecasts that Rachel Reeves only has a 54% chance of achieving her target of a current surplus in five years’ time. Developments have taken a turn for the worse since the Budget. Government borrowing costs are now considerably higher than those assumed by the OBR’s assessment following pressure on gilt yields on both Budget day and the day after; the Bank of England’s most recent growth forecasts are more pessimistic than the OBR’s (as they often are); and the prospect of tariffs following the US election provides another downside risk to growth (which Johan Lof talks about in greater detail in the section below). It is also notable that the most recent UK PMI readings make for worrying reading. The flash PMI for November took an unexpected drop down to 49.9 (October: 51.8), with the decline in sentiment being linked to Budget measures that have increased payroll costs and disincentivised hiring new staff. Taken together, and all other things equal, this would strongly suggest that Ms Reeves is not on course not to meet her fiscal targets.

Of course, that is not the end of the story. The new government is indicating a willingness to implement measures that could improve the productive potential of the economy. The Chancellor’s Mansion House speech set out a positive vision both in making financial services regulation more conducive to growth and promoting reforms to pensions that could free up capital for investment in infrastructure. Her intention to reform planning rules that could deliver higher levels of housing would also be a big boon to the UK economy’s economic potential. However, many of these reforms will be challenging to deliver and, in any case, may only show significant dividends beyond the current parliamentary term. 

The outlook for the UK remains uncertain, although it is always worth emphasising that relative political stability here should serve as a tailwind to growth. Moreover, other major European economies face many of their own challenges: concerns associated with political risk will bubble away in France; Italy’s debt pile remains a perennial problem; and Germany’s growth prospects continue to struggle following its forced pivot away from Russian energy and its export-orientated growth model being hit. 

A final word on our current rate forecast. Following an inflationary Budget and the prospect of a further inflationary impulse from developments in the US, we have revised our interest rate forecast and are now forecasting fewer interest rate cuts over the coming 18 months. Our current projection is for there to be only a further four interest rate cuts between now and 2026, with rates settling at 3.75%.

Daniel Mahoney, UK Economist

USA: Declarations of victory in the inflation fight have been made too soon 

• We believe that the taming of inflation has been declared prematurely. 
• Not only is US inflation still too high and sensitive to new shocks, it is also likely to be stoked by president-elect Donald Trump’s planned policies.
• So far the Trump camp and Treasury Secretary candidate Scott Bessent appears to be turning a blind eye, but the bond market is on high alert.
• If inflation does indeed return with a vengeance, when will the Fed react? 

Declarations of victory in the fight to lower inflation have been made too soon. US inflation outcomes remain too high, including the recent monthly clip even pointing to a pickup ahead – needless to say, not consistent with reaching the 2-percent target. The current setback may not be as big as the one experienced in early 2024, but that is a small comfort, as October could post a trend-breaking rise in the Fed's underlying inflation dashboard (see chart, the last of the October data published 27 Nov and the following days).

Long-term inflation expectations have risen during the inflation-crisis years, but at first glance they have remained anchored at levels consistent with credibility in the Federal Reserve’s 2-percent inflation target. The observation of "anchored" inflation expectations has made central bankers and economists state that the worst of the crisis is likely behind us. In our view, this conclusion does not rest on strong foundations, and we believe that there is a risk that the economy is not equipped to fend off the next inflation shock. Why? Two of the reasons are:

• Firstly, the flipside of the still-strong US economy is that it risks propagating any new inflation shocks by more than average. Note for example that while the labour market has moved into better balance, it remains tight with a vacancy-to-unemployed ratio above 1. In this state, any positive surprises to demand in the economy has a higher tendency to drive outsized inflationary impulses.
• Secondly, inflation risk and uncertainty is elevated. The balance of inflation risks is tilted upwards, according to derivatives markets. In addition, inflation uncertainty remains unusually high even today, after two years of gradual disinflation, as evidenced by household survey expectations exhibiting a much broader uncertainty band.

Looking ahead, president-elect Donald Trump’s policy plan is inflationary according to the economist consensus and our reading of the recent bond market reactions. However, the Trump camp and Treasury Secretary candidate Scott Bessent appear so far to be turning a blind eye. How will the Fed react to the current setback in inflation progress and the prospect of fiscal and other government policies likely becoming more inflationary? At its November meeting, Fed Chair, Jerome Powell, made it clear that the Fed would not speculate about or assume future policy. We do not think this implies that it will wait for policy to be enacted, because a Fed diligently acting on data will likely find inflation risk proof earlier, e.g. because government signals also affect markets and the economy.

One thing that would cause the Fed to slow or pause rate cuts is resurgent inflation and inflation expectations. Short-term expectations are still mostly above their pre-pandemic averages, and any increase could raise worries about the long-term inflation expectations being next in line. If the timing and mix of Trump's policy communication initially causes a negative supply shock (e.g. tariff increases and migration cuts), then expectations, commodity prices and perhaps some survey data could be places where we can track the impact. Another scenario is that Trump's policies initially create a positive demand shock in the economy (e.g. a sentiment boost from deregulation and promised fiscal stimulus), and then the Fed may adapt its policy to better-than-expected economic activity data before the effects on inflation are significant. Remember that the Fed is already in a position where it is considering pausing its rate cuts due to the inflation setback. The most likely outcome is perhaps some combination of net-negative supply and net-positive demand shocks in 2025 – an inflationary environment, to say the least.

Our next Global Macro Forecast report is out on 22 January 2025, with full updates on the US outlook and its impact on the world, including China and Handelsbanken's main markets. Until then, please check out our new Macro Comment “Back with a vengeance – Inflation to haunt Trump too Opens in a new window”.

Johan Löf, Head of Forecasting

The dust is now starting to settle after a bumper month as the UK Budget and US Election were the forefront of markets’ minds. Throw the Bank of England and Federal Reserve central bank decisions in the mix and it’s all-go for November. 

UK Budget throws cold water on the cutting cycle plan

The budget was delivered with best intentions, but it doesn’t take much to rock the boat. As Dan talks about above, there are some fundamental flaws highlighted in the aftermath of Rachel Reeves’ budget. In the build-up to Budget day on 30 October, we saw gilt yields move higher on the expectation that increased spending would require increased gilt issuance from the Labour government in its coming years in Downing Street. The intention to adjust the definition of debt had circulated in the media in the weeks leading up to the Budget, so the increase in gilt yields off the back of this meant it didn’t come as a huge surprise on Budget day when this was confirmed by the Chancellor. 

However, the devil in the detail as ever is what moved markets. UK bond yields actually dipped initially while the Chancellor was presenting her Budget, as markets looked favourably on her comments that the tax hikes would raise £40bn per year. However, this dip was reversed fairly quickly. 10-year gilt yields swung up 15bps as markets digested how much borrowing is forecast to rise over the next few years. This was solidified by the report published by the independent Office for Budget Responsibility which highlighted that the aggregated effect of the new Budget measures would increase borrowing by an average of £32.3bn over the next five years, and will increase the current budget deficit by an average of £9.3bn per year given the increase in spending isn’t offset by an increase in tax receipts. Additionally, CPI is expected to rise to 2.6% in 2025 before falling away more gradually, in part due to the Budget. A further 11bps increase in gilt yields was seen the following day as the Institute for Fiscal Studies published concerns around the sustainability of tax receipts if growth falls short.

Since Budget day, UK gilt yields have continued to trend upwards, particularly in the build up to the US election. Comparing expectations for how the Bank of England’s cutting path is expected to play out, if we look at how this was projected pre-Budget, the path had one more cut fully priced in this year, and then a further three cuts priced in by September’s meeting next year. Contrasting that to where we sit now, the Bank of England delivered that one cut as expected, but we only have two cuts now fully priced in by September 2025, of which the next cut isn’t fully priced in until the March meeting. Higher-for-longer is now back on the cards for the path of UK interest rates.

The Bank of England meeting on 7 November saw the widely-expected 25bp cut delivered by the MPC, with an 8-1 voting split to cut. The one vote to hold was from Catherine Mann, arguably the most hawkish member of the committee. The guidance was left unchanged, touting that “a gradual approach to removing policy restraint remains appropriate”. The decision was peppered with hawkish undertones as Governor Andrew Bailey re-iterated in his press conference that rates wouldn’t be cut “too quickly or by too much”, and the 2-year swap rate increased around 5bps in the minutes after the announcement. In a speech mid-month Ms Mann commented that inflation has not been “vanquished” yet, supporting her rationale behind her vote to hold at the latest meeting.

The October inflation figures didn’t help this narrative for sticky inflation either. The hotter-than-expected print came in 0.1% above expectations from both markets and Bank of England, with Y-o-Y CPI figures up from 1.7% in September to 2.3% in October. This is largely attributed to the base effect in the electricity and gas component of the inflation basket, and following the increase to Ofgem’s price cap. Services inflation remains in the spotlight at 5% (expected 4.9%) Y-o-Y reading, owing to airfares increasing, which is not typical for October when airfare prices tend to fall. 10-year swap pricing moved 5bps upwards on the back of the inflation figures. Market pricing adjusted in the immediate aftermath to price in just a 10% chance of a rate cut at December’s meeting, but it remains the case that the March meeting is the next fully priced in rate cut on the cards.

‘Trump Trade’ prevails after Red Sweep election result

Guy Fawkes Night for the UK ended with a bang in the US as the early election night results showed a Donald Trump win. The 10-year US treasury yield rose from 4.25% to above 4.40% in the immediate aftermath, reflecting the inflationary expectations of a Trump presidency for the US. We saw respite for yields in the lead-up to the Federal Reserve meeting on 7 November, which saw the 10-year yield fall to 4.32% ahead of the meeting, and a further 2bps over the course of the next 24 hours.

However, bond markets see the ‘Trump trade’ as full steam ahead, as we saw a rebound on 12 November back to yields in the 4.40% region which has remained as the Republicans took a ‘Red Sweep’ win of the election. The language in the Federal Open Markets Committee’s statement published in the aftermath of the meeting was interpreted by markets as hawkish, with one of the main focal points being the removal in full of the sentence about having “gained great confidence” in achieving their inflation target. This was reiterated by Chair Jerome Powell at an event with the Dallas Regional Chamber, signalling that the Fed is in no rush to cut rates owing to the strong US economy and there being “no need to be in a hurry to lower rates”.

Markets continue to shift their expectations for rate cuts next year, and it’s a similar story in the US and for the UK – higher-for-longer with fewer cuts throughout 2025. The next rate cut isn’t fully priced in until March 2025, with a 55% chance of a cut at the December meeting. One driver for this is if inflation remains persistent. Compared to September’s CPI reading coming in hotter than expected at 2.4%, October’s reading was on target -  higher at 2.6%. There was a sigh of relief to some extent by markets, but this reading is still too high for the Federal Reserve’s liking. Now that the ‘Red Sweep’ has been solidified, Trump’s policies will in theory be easier for him to pass through from idea to action. His suite of policies is expected to be growth-positive, therefore sufficiently restrictive monetary policy remains required to contain inflation. As Johan talks about above, markets and economists alike currently are expecting an inflationary environment under a Trump presidency – the question is how far will he push policy once he is in situ?

Jasmine Crabb, Capital Markets