Fed kicks off with a 50bp cut, but have market rates hit a floor for now?

After August saw the first UK rate cut of this cycle following an Monetary Policy Committee vote that was split by the finest of margins, the decision by the Bank of England to hold rates at 5% in September was determined by a comprehensive majority with only one member of the committee dissenting. The MPC was also unanimously agreed in continuing the process of quantitative tightening (QT) at £100bn per year. This decision on QT is unlikely to have any significant implications for monetary policy transmission, although it will slightly reduce costs to the Treasury due to the fact that fewer gilts will need to be actively sold compared to previous rounds of QT. 

The latest y-o-y CPI print for August registered at 2.2%, notably below the MPC’s latest forecast of 2.4%, but this was not enough to convince the MPC to continue its rate cutting cycle. A combination of high services inflation, high nominal wage growth and broader concerns around the labour market (for example, the worrying growth in inactivity rates) meant the vast majority of MPC members need to see further evidence of disinflation before backing another rate cut. 

Our current economic outlook for the UK can be viewed in Handelsbanken’s latest Global Macro Forecast Opens in a new window, something that we publish three times a year. In light of the succession of shocks to hit the UK economy, the base-case scenario is a relatively sanguine one with modest projected growth of 1.1% in 2024 and 1.6% in both 2025 and 2026. As mentioned in the previous Rate Wrap, growth in real wages and the potential for savings rates to fall should help provide a reasonable tailwind to UK growth in the coming 18 months or so. 

Of course, there are a series of risks that could upset this relatively sanguine outlook. There has been widespread speculation as to what taxation measures could be contained within the Budget of 30 October. Fears around this are showing up in confidence metrics: consumer confidence nosedived in September, registering at -20, down from -13, and the most commonly-cited concern in the latest PMI data was fiscal policy uncertainty ahead of the Budget. We hope this hit to confidence will be short-lived, especially since our “Misery Index” suggests that fundamentals of the UK economy do not warrant this kind of pessimism (see Figure 2).

The potential risk to confidence from international developments could end up being more material. The US election, just one week after the UK Budget, has the potential to prompt significant public policy changes from the world’s largest economy that could end up reverberating around the global economy. Then, of course, there are potential short-term energy shocks arising from escalating conflict in the Middle East along with more medium-term risks associated with the conflict between China and Taiwan that could end up causing major disruptions to the supply chain of semi-conductors. I suspect these international issues may start featuring more prominently in the economic outlooks of developed nations as 2024 progresses and we go into 2025. 

For now, our base-case view on interest policy remains that set out the Global Macro Forecast. This suggests that inflation may end up being more stubborn than the Bank of England’s latest modal projection and that, while rates are expected to continue falling, the pace will be slow and smooth. Our expectations are for there to be a further rate cut down to 4.75% in November, with base rate gradually falling to 3% over the course of the next two years. We currently believe that neutral rates lie somewhere just beneath 3%, meaning that monetary policy would still be restrictive at this level. 

Daniel Mahoney, UK Economist

Federal Reserve in the spotlight

September was a busy month for central banks and markets alike, despite the month also bringing  meetings from both the Bank of England and the European Central Bank – the markets’ focus was solely on the Federal Reserve as it starts the journey of reducing rates from restrictive territory. As a quick reminder, markets had a wobble in early August following the US July payrolls report which printed a lot weaker than expected, subsequently followed by a few data releases that were soft, but far from in alarming territory. Nevertheless, markets in their wisdom (or perhaps just panic) doubled down on calls for an aggressive cycle of rate cuts starting in September in the US, on fears the US was heading towards a “hard” landing. Naturally as the month progressed conditions started to calm, with nerves that the Fed is again behind the curve eased by snippets of better data, but markets remained undecided on whether the Fed would start the easing cycle cautiously (25bp cut) or with a bang (50bp cut). 

The focus has clearly shifted from the battle against inflation, to trends in the labour market. Put differently the Fed is no longer on autopilot, keeping rates restrictive to tackle inflation, but instead looking to manually steer policy, and the US economy, towards a “soft” rather than “hard” landing. 

The August payroll data (released in September) was weak again, but not weak enough to call “mayday!” through the pilot radio just yet. Payrolls expanded by 142,000 in August, slightly below consensus expectations but given the range of estimates it did not mean a great deal. Markets seemed poised for a lower number, so the fact that payroll number stayed north of 100k was probably seen as a success. Revisions to the previous data was still a concern, which has become a bit of a trend. Nevertheless employment growth is not falling, just slowing, and we also had a slight surprise in the monthly core inflation numbers (rising 0.3% month-on-month, vs 0.2% expected) – driven by housing costs. These datasets probably briefly tipped the balance towards a smaller 25bp cut in September, but a WSJ article released soon after, detailed (citing comments from former Fed members and advisors) that the decision may still be a close call –  therefore keeping hopes of a larger 50bp move alive.

Once the Fed meeting arrived, a 50bp move was still gaining momentum, and ultimately those punters proved correct, with 11 of the 12 voting members of the Fed backing a 50bp move. Naturally, given the market was not full discounting this move, you would maybe expect to see some sharp market movements – but equally there is always a risk of a “buy the rumour, sell the fact” scenario. The latter proved to be the case, with rather sanguine market moves post decision and press conference. We did see the curve steepen again, with shorter-dated yields coming under pressure whilst longer dated yields moved a touch higher. The 2s/10s US Treasury curve (10y yield minus 2y yield) now sits at around 0.10% - no longer inverted.

The Fed’s interest rate forecasts (the dot plot) endorsed market pricing for another 50bp worth of cuts in 2024 over the remaining two meetings, but for 2025 the median suggests another 100bp of easing. Market pricing for cuts in 2025 is more aggressive, with futures pointing to the Fed Funds rate settling below 3% by the end of next year.

In summary, the Fed took the opportunity that markets presented to kickstart the easing cycle with a bang, without causing upset or alarm about economic trajectory. The (lack of) market reaction will be viewed as a success in the Fed’s eyes, but now likely sets a high bar for market rates to take another significant step lower in the short-term. This suggests the path of least resistance could be for moderately higher rates over the next few weeks. We may well be in the same situation at the November meeting, debating between a 25bp and 50bp move, but that will be determined particular by the evolving labour market picture.

Consecutive cut from ECB in October?

Elsewhere, we should mention the European Central Bank cutting the deposit rate by another 0.25% down to 3.5%, whilst also reducing the spread between the deposit rate and the refinancing rate to 15bps from 50bps. This is a technical adjustment following a recent framework review, and not seen as policy easing as such. Bank President Christine Lagarde gave little away in the press conference, with the central bank sticking to data dependency, but noting that the direction of travel is “pretty obvious”, with further rates cuts to come. But with soft growth and preliminary inflation numbers for September (1.8% annual headline inflation in the Eurozone), calls within the central bank to cut rates again in October is growing, even from the more hawkish members. Subsequent comments from Lagarde that the ECB is becoming “more optimistic” on getting inflation under control further hints at another 0.25% cut in October, which markets are now fully pricing in.

Hawkish hold from the BOE

The September Bank of England decision was expected to be a non-event, comments from Governor Andrew Bailey at the Jackson Hole Symposium in late August noted caution around the inflation pathway, which was further evidenced in the August numbers with annual services inflation increasing to 5.6% (albeit in line with forecasts) – put simply the data did not warrant a consecutive September cut. The decision was very much a hawkish hold, with the MPC voting 8-1 to keep Bank Rate at 5% - perhaps a slight surprise to some that Dave Ramsden switched back to voting to hold with the majority. The press release further pointed to lingering concerns around inflation, which supports the view that future reductions to interest rates will be gradual.

With the slight hawkish surprise we did see market rates readjust higher, now only fully discounting one more cut this year (in November), albeit not ruling out a chance of another in December. Altogether around 10bp of cuts have been priced out by the summer of 2025 – so not a significant reaction by any means. In the context of UK rates, it was well known that the Fed meeting was going to be more important than the BoE this month. The pressure seen on swap rates in the past two months has almost been entirely driven by US developments. If swap rates were to take another leg lower, it was not going to be the BoE driving that. As mentioned above, the euphoria around a larger Fed cut quickly faded as it became a reality - halting the downward momentum - therefore it suggests that UK swap rates may have hit a floor for now – at below 4% across the whole curve.

Going forward the question will be whether the current gap in market pricing between the US and UK will close – either by the BoE turning more dovish, or by the Fed reigning in market expectations for cuts. The gap however will likely remain for a few months until there is a clearer picture on US economic health. Our economists’ forecasts suggest that UK inflation may prove stickier, which supports a more cautious approach from the BoE, so for the gap to close this may have to come from a more hawkish Fed – one to watch!

Eyes turn to the US election

The obvious risk to the current market pricing for rate cuts in the US is the upcoming US election – which currently has both candidates, Harris and Trump, tied according to the latest polls. Given this is a Rate Wrap, we will not go into detail on the various policies, but we can simplify what the market impact may be. In the short-term, many argue a Trump presidency would be more inflationary relative to a Harris presidency, characterised by tax cuts driving economic growth, and increased tariffs on imports. This in turn should lead to a markedly hawkish Fed (and therefore narrow the aforementioned gap to the UK curve). We stress this is a simplified view, a Harris presidency can still be inflationary – ignited by spending plans and tax credits, whilst the makeup of Congress can dilute or amplify these effects. One thing that is clear, is that neither presidency is likely to address the long term sustainability of government debt. 

We will touch on this more in the coming months as the outcome becomes clearer.

Cameron Willard, Capital Markets

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