Did markets get ahead of themselves on potential rate cuts?

BoE likely to remain cautious in February

Consumer UK retail spending was surprisingly depressed in December, down 2.4% on the year even though expectations were for a modest rise in sales. GDP growth in Q3 2023 registered at -0.1% and it was finely-balanced as to whether Q4 would post negative growth. December’s retail sales print would imply that Q4 may have seen a contraction, which would put the UK in a technical recession (two consecutive quarters of negative growth). While this would no doubt prompt headlines across the news bulletins, the recession would be very shallow and it is important to stress that economic activity is bound to pick up in 2024 as real wages continue to grow. 

Looking ahead, the Bank of England Monetary Policy Committee (MPC) meeting on 1 February will, of course, be closely-watched by market participants keen to get a steer on the pathway of monetary policy in 2024. There is plenty of data for members of the committee to chew over, much of which will be welcomed by the BoE. For example, there seems to be a sustained cooling in nominal wages: regular pay has come down from 7.9% in August to 6.6% in November. It is notable that these earnings numbers are not affected by data quantity problems in the Labour Force Survey. Moreover, December’s inflation registered at 4%, which is quite some way below the BoE’s November forecast.

However, the financial market reaction to December’s inflation print highlights that a large level of uncertainty remains. A relatively minor overshooting of the print above market expectations led to traders slashing the number of predicted interest rate cuts in 2024 from five to four. Moreover, while indications suggest that inflation will continue to come down from its current level of 4%, getting to 2% inflation on a sustained basis remains a challenge. Catherine Mann, one of the more hawkish MPC members, notes that goods inflation needs to be -1% and services around 3% if the configuration between goods and services were to return to where it was in the last 20 years. Yet current goods inflation is circa 2% and services inflation is circa 6% (see Figure 3). And, of course, geopolitical turmoil also presents upside risks to the inflation outlook via channels including the energy market, shipping costs and supply chain disruption. All of this will serve to make the BoE cautious.

The US Federal Reserve has already explicitly set out its view that interest rate cuts are on the horizon yet there remains enough uncertainty to stop the BoE following suit at its February meeting. However, the downward trajectory of nominal wages and UK inflation registering below the BoE’s expectations could lead the MPC to moderate its hawkish language at the February meeting. Handelsbanken’s current house view is that rate cuts will begin in June, and that there will be a total of three 0.25pp rate cuts in 2024. 

For more on Handelsbanken’s economic outlook for 2024, please see our latest Global Macro Forecast Opens in a new window.

Daniel Mahoney, UK Economist

The start of 2024 has been characterised by markets seemingly battling their own thoughts on the scale and pace of interest rate cuts this year. The last quarter of 2023 saw a rapid rally in bonds as data started to turn, inflation started to slow and central banks more or less closed the book on any further rate increases. There were always question marks about whether markets had gone too far (it’s not uncommon) in their pricing for cuts, especially given that the decision-makers themselves gave no clear endorsement of such a path. The Fed has signalled 75bps of rate cuts this year, around half of what markets are pricing in. Nevertheless when the trend is your friend it is easy to jump on the bandwagon, and there was always going to be a point when doubt in some starts to creep in.

In the first few trading weeks of 2024 this was the case, perhaps as the Christmas and New Year hangover hit home. We saw market rates increase across the curve, and this was the cause of equity markets also having a wobbly start to the year. In comparison to the end of Q3 last year, rates are much lower still, but we did see the 10-year Treasury yield rise above 4% again, and the UK equivalent Gilt has risen from lows of around 3.45% before year end to around 3.90% now – swap rates have also followed suit as well. This was not hugely surprising as the rapid monetary policy loosening priced in by markets contradicted the key data releases published so far this year. US data is key for rates globally, and both the latest employment numbers and inflation prints both came out higher than expected. A similar story came through in UK inflation figures which came out hotter than anticipated – while softer wage data will bring a sigh of relief for the Bank of England to some degree, stickier inflation remains a concern and has pushed back on market pricing. The complete lack of reference potential rate cuts from the Bank of England gives an indication that they are not comfortable to even entertain current market pricing, but that may change in February. 

The change in US nonfarm payrolls for December exceeded expectations by 41,000, coming in at 216k. Furthermore the unemployment rate held steady at 3.7% (a rise to 3.8% was expected) and average hourly earnings also beat expectations, rising 0.4% month-on-month. Some context around the first two numbers is needed, as the rise in nonfarm payrolls is being driven by a narrow set of sectors (government, education and health, hospitality) which is not a sign of sustainable growth. Secondly the unemployment rate only failed to rise as the size of the labour force dropped simultaneously – indeed the alternative household survey showed a steep drop in employment. Despite this the wage numbers will be what the Federal Reserve continues to watch, and the official numbers are not consistent with a steep drop in rates that the market is predicting. Nevertheless other surveys of pay growth do point to softer numbers ahead, so there is some logic behind the market pricing.

Markets would not have liked the US inflation numbers for December though, with the annual headline rate rising to 3.4%, and the core equivalent slowing only to 3.9%. These were slightly above expectations, but not a significant difference – this just highlights that getting inflation back down to the 2% target will not be easy, and there will be bumps along the way. Within the report, inflation in housing components and used car prices amongst others remained strong. Like with employment, other data still supports inflation slowing towards target in the coming months, but based on the available data it is hard to justify the Fed pressing ahead with cuts as early as March. 

Markets are now split, pricing in with c.50% probability that we will see the first cut in March, with a fair probability of cuts at every single meeting thereafter this year. One justification is that the Fed’s preferred measure of inflation (personal consumption expenditure deflator – PCE) is running at a slower pace than the CPI data, only due to differences in methodology. As of now, it’s a tough call, and we will wait to hear from the Fed Chair Jay Powell at the Fed meeting at the end of January. Eurozone data is not as impressive, and with core inflation heading sub 3%, and growth waning, even the ECB cannot fight the markets in pricing in a cut as early as April, despite Christine Lagarde in the January meeting reaffirming that cuts are more likely in the summer. In the UK as of now there is focus on the May meeting for a cut, whilst at least one cut is fully priced in for June.

Cameron Willard, Capital Markets

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