Last week’s European Central Bank meeting continued the theme of near-relentless rate rises for the past 18 months. This week saw a change.
US Federal Reserve (Fed)
In its latest meeting, the Fed kept rates on hold at 5.25%-5.50% as was widely expected by markets. Prior to the meeting the market had less than a 5% chance priced that they would raise rates and were more focused on how many cuts were priced in for 2024. To be precise, the market had assumed that the Fed would be cutting rates by 100 basis points (bps) in 2024. Therefore, the main exercise of the Fed decision last night was communication, attempting to talk down the markets laissez-faire attitude to high inflation.
Fed Chairman Powell was at pains to make the point that the economy was still expanding at a “solid pace” and that the committee still project another hike this year. He also suggested that the market assumption of 100bps of cuts in 2024 was optimistic and the Fed themselves have pencilled in only 50bps of rate cuts in their projections. He also went on to mention that rates have come a long way and that it made sense to pause now and assess additional data over the coming months to truly establish if inflation was under control. In short, they want to ensure that the job is done and stamp out any chance of a second inflationary pulse before considering rate cuts.
The markets were slightly caught out by this ‘hawkish hold’ with short-dated treasuries bearing the brunt, with yields rising by 15-20bps as future rate cuts were priced out. Long-dated bonds fared slightly better initially, however yields here started to drift higher as the market fully contemplated the idea of a ‘higher for longer’ stance to policy. Short-dated breakeven rates drifted lower, but only very slightly, as US inflation assets were already fairly priced for a view that reflects inflation only slightly above target over the medium term. Time will tell if this is the peak in rates and in the short term, further energy price moves may continue to muddy the waters a bit. But what we can be sure of is continued market volatility around upcoming economic data prints, which is the perfect environment for an active manager.
Bank of England (BoE)
At its most recent meeting, the BoE Monetary Policy Committee (MPC) voted to keep rates on hold at 5.25%, by five votes to four; its first unchanged vote in 15 meetings. This followed hotly on the back of the Fed meeting on 20 September, where the Fed also elected to keep rates on hold.
The decision to leave UK base rates unchanged was, by the time of the meeting, well priced by the market; the probability of a rate hike had fallen from around 80% late on Tuesday to just above 50% on Thursday morning. Central to this was August inflation data (released on 20 September) where Consumer Price Inflation (CPI) unexpectedly fell. Of particular note was the move in core CPI, which fell from 6.9% to 6.2% year on year in August; it had been expected to fall by just 0.1% to 6.8%.
After 14 consecutive hikes (since December 2021), the BoE has finally paused its hiking cycle. Market pricing for peak rates has fallen significantly from 6.5% in early July to 5.4% today. The market is, unsurprisingly, suggesting that the BoE is now close to or at peak rates. There are signs that the labour market is starting to weaken as vacancy rates fall and unemployment rises. Growth also remains sluggish, and forward-looking indicators such as Purchasing Managers' Indexes have fallen below the key 50 mark. And finally, as evidenced on Wednesday, inflation is falling, and is expected to take another leg lower into the year end as the base effects of last year’s high energy prices drop out of the year-on-year calculation.
Whilst the markets pricing for peak rates now looks more balanced than a few months ago, the market may be underestimating just how long the BoE may have to remain on hold at its peak, whether that peak be 5.25% or a little higher. Rate cuts are now well priced, with 50bps of cuts priced for 2024. With inflation remaining persistently high in absolute terms, the BoE’s CPI target of 2% still looks someway off, and a leap of faith is required before the BoE can start cutting.
Gilts have performed well since the summer highs in yields. Yields on short-dated five-year gilts are currently 4.4%, 80bps lower than their peak in early July. Contrast this to the US, where five-year maturity bonds are making new yield highs, and suddenly gilt yields are starting to look less attractive in a global context. As a result, we are less positive on gilts, with dollar markets looking more attractive as yields are either flat or higher than the UK.
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