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Deja Vu

It is taken as read that central banks will soon start to cut interest rates. After all, inflation is decelerating, unemployment is slowly rising, whilst many parts of the economy still have to adjust to previous monetary tightening. At present traders are pricing in rate cuts in some countries of at least 1.0%, potentially 1.25-1.5% during 2024, with the first decline possibly as soon as March and otherwise beginning in Q2. Is that correct? Markets have gone down this path before and had to retreat!

A ’soft landing’ has certainly become the consensus view for the US economy. After strong growth in Q3, revised up to 5.2% on an annualised basis, the final quarter of the year looks to be returning to a more normal 1-2% level. New home sales show the lagged impact of higher mortgage rates, the Biege Book Fed regional survey reports activity easing, whilst there is evidence of a weakening labour market. Nevertheless, the extent of the slowdown in activity should not be over-estimated; the important ISM business services index rose from 51.8 to 52.7 in November.

At the same time, inflation is decelerating. The three-month annualized rise in US core personal consumer expenditure inflation has eased to 2.4%. Inflation expectations as embedded in the markets have similarly declined, although they remain above the Fed’s long-term target.

Analysts are speculating that the first rate cut could appear in Q2. There is support from some Fed officials, for example Christopher Waller signalled that the inflation battle was nearly won whilst Goolsbee said he definitely  has some concerns about the Fed keeping rates too high for too long. More importantly, though, Jerome Powell remains equivocal. “It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease”.

Markets have jumped to the conclusion that the ECB could cut rates before the Fed! The backdrop in Europe is even weaker than across the Atlantic, with marginal economic growth at best into Q4. While the latest German Ifo business survey edged up, factory orders remain weak probably reflecting the continued weakness in the Chinese economy. Declines in Dutch, German and Spanish headline inflation paved the way for the Eurozone CPI figure to ease from 2.9% to 2.4% a year. Lower oil prices could help headline inflation to ease further into 2024.

The ECB seems to be falling into three camps. The likes of Vice President Luis de Guindos fear the economy is probably already stagnating, whilst risks to the current growth outlook are on the downside; indeed Pablo Hernandez de Coscos said that there is the possibility of a recession. Others are more even handed. Christine Lagarde noted that the central bank is now at a point where it can pause and assess the impact of its tightening, as “we have already done a lot”. Isabel Schnabel said inflation is “falling more quickly than we had expected” making another hike in rates “rather unlikely”. A third group is standing firm; Francois Villeroy de Galhau said that, barring shocks, the ECB would consider the question of easing in 2024, although only in the second half of the year. Luis de Guindos said “it was too early to declare victory”.

The UK economy is also in a poor state but of course core inflation looks more embedded than in the USA or Europe. Andrew Bailey has admitted that the outlook for economic growth was not good. This reflects a bout of subdued consumer spending data; the latest CBI retail sales report showed some improvement, but the BRC/KPMG survey was more downbeat indicating that pre-Christmas discounts were failing to lure shoppers. Nevertheless, Bailey still argued that stubborn inflation meant that it would be a long time before interest rates could be cut “rates are likely to need to remain at these levels for an extended period to bring inflation back to target on a sustained basis”.

Although the economic picture remains murky in many respects, moves in bond markets in the past few weeks have been significant. The UK 10 year gilt yield has fallen below 4% for the first time since May, the German 10 year yield is the lowest since April, whilst the US benchmark yield has round tripped from 3.75% to 5% to under 4.25% in the past six months. However, it is very important to remember that market expectations are often wrong, and have been so several times in the past year. Markets are pricing in a soft landing, but stubborn inflation or a swerve into deeper recession could significantly affect market expectations in coming weeks and months.

Bond yields close Thursday 7 December

10 year %                     Weekly Move               Monthly move

USA                              4.15                             -0.20%                          -0.37%

UK                                3.99                             +0.18%                         -0.25%

Germany                      2.18                             +0.26%                         -0.43%

Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.



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