So where are we on the mountain?
At the last round of central bank meetings, the US Federal Reserve (Fed), the European Central Bank (ECB), and the BoE kept rates on hold.
In our view, all three have hit peak rates. The transmission mechanisms are working. Economies are slowing, while inflation is receding. The moves higher in global yields over the summer, particularly in the US, were what central banks needed: tightening financial markets without them having to tighten monetary policy.
Admittedly, some transmission mechanisms are slower than others. For example, as the BoE chart shows, the UK may have a great deal of pain to come.
Chart 1. Increases in interest rates expected to continue to reduce consumption
Source: Bank of England, Monetary Policy Report, Nov 23.
Despite this, central bankers still allude to the prospect of hikes in their press conferences.
True, the inflation battle is not over. Headline numbers are a long way from hitting mandated levels. Labour markets, while loosening, remain tight. Monetary policy therefore needs to be restrictive in the here and now.
Chart 2. Headline CPI
Source: Bloomberg, November 2023.
What happens after that?
Central Banks know that markets expect rate cuts after rate hikes. But markets have short attention spans. Central banks must maintain the threat of rate hikes so the market resists pricing in aggressive rate cuts. Policymakers cannot afford financial conditions to loosen too quickly.
Will central banks follow the "Table Mountain" rate profile?
For a while, but not for long.
Given this, we offer an alternative to the “Table Mountain” analogy. We are currently at the mountain plateau. The economic storm clouds are rolling in. It is nearly time to ride the cable car back down. However, we are not descending to the foot of the mountain. Policymakers will likely pause halfway, take in the view and observe the economic weather before making their next moves.
In other words, we expect rates to fall from their peak but remain elevated for some time.
How does this look in the real world?
By the second quarter of 2024, rate cuts will be firmly on the agenda. These will be billed as ‘fine-tuning’. Nonetheless, monetary policy will still be restrictive. Central Banks will remain vigilant and communicate their readiness to retighten if signs of persistent inflation re-emerge. Again, this will be designed to prevent market participants from jumping ahead of themselves.
Who cuts first?
Markets do not price a clear winner, but we are likely to
see the first cut by the end of summer 2024. From there, we expect a slow,
consistent descent compared to the bumpy ride markets endured on the way up the
As it stands, markets are forecasting all three major central banks will cut three times in 2024. Cuts are priced to continue in 2025. This will see the Fed getting to roughly 4% (current target rate 5.50%), the ECB to 2.75% (from 4%), and the BoE to 4% (from 5.25%).
This is where we disagree. We think rates have further to go.
Permit us a little economic theory. We do not question the
notion that neutral rates (R*) are higher. (R* is the theoretical level where
monetary policy is neither contractionary nor expansionary). Globalisation
peaked in the last decade and is now reversing. Covid-19 has accelerated the
process. Brexit was another influential factor. These elements increase
structural inflation, which is why we don’t expect policy rates to reach the
bottom of the mountain.
So, we agree that neutral rates may be higher, but not as high as the markets are pricing.
Do we need a 'hard' recession for rates to fall?
Base rates are currently restrictive. Monetary policy is working. Activity data is slowing. This will be enough for central banks to start cutting.
Even if inflation remains sticky, we think central banks will not want to continue hiking. Policymakers believe there’s enough tightening in the system to take inflation back towards target. An additional question is whether central banks will be overly concerned if inflation stays slightly north of 2%? We believe a small margin above 2% would be manageable.
Implications for markets
Looking back, 2023 was supposed to belong to fixed income.
More resilient economies put paid to that. Whisper it quietly, though…. fixed
income and sovereign yields look appealing at current levels.
For funds that can take on inflation risk, owning real yields at various maturities could be a profitable strategy. This potentially affords investors positive nominal returns on future interest-rate cuts. Exposure to inflation breakevens, which don’t appear expensive, could further support this position.
We believe that policy rates have peaked. Inflation is on a
path back towards central banks’ targets. Against this backdrop, we see value
in UK gilts. We also believe the return outlook for European and global
government bond markets is strong. Inflation-linked bonds remain a compelling
investment, as weaker economic growth and elevated inflation provide tailwinds
to the asset class.
Given this view, we think developed market government bonds offer value at current yields.