It was widely expected that Fed Chairman Jay Powell’s main challenge yesterday would be to push back the idea that the Federal Reserve is ready to cut interest rates sharply over the next 12 months. With yields falling sharply since November, there was an expectation that the loosening of financial conditions could jeopardize central banks’ fight against inflation.
It was therefore quite surprising that yesterday’s statement and the dot plots embraced this narrative and gave the markets an early Christmas present, with the median dot plot for 2024 back to 4.6%, where it was in September, while core PCE is forecast to fall to 2.4%.
The US dollar sank along with 2-year yields, which fell 30bps to a 6-month low, gold surged back above $2,000 an ounce, and US markets rallied to their highest levels this year, with the Dow hitting a new record high, confounding market expectations of a hawkish push.
At the press conference, Powell tried to give the impression that the Fed retained the option to raise rates again, but this message is rather undermined by the fact that the FOMC lowered their dot projections by as much as they did. The admission that the FOMC discussed rate cuts was also noteworthy.
If “higher for longer” wasn’t dead before last night, it certainly is now, and certainly makes the job of both the Bank of England and the ECB later today that much harder to maintain a hawkish bias, with European markets set to open sharply higher, with new record highs expected for the DAX and CAC 40.
Having seen the Federal Reserve leave rates unchanged yesterday, it is now the turn of the Bank of England and the ECB to follow suit, as well as try to navigate the messaging of when they expect to start cutting.
When the Bank of England decided to keep rates on hold in September, it was a close call, but on balance it was probably the right decision given the challenges facing the economy as we head into year-end.
Those challenges have come into sharper focus this week with wage growth slowing to 7.3% and the economy contracting by -0.3% in October. This week’s data has prompted markets to price in the prospect that the BOE will prioritize the UK economy over the fight against inflation, with yields falling sharply to their lowest levels since June.
The emphasis in recent meetings on what has become a “Table Mountain” approach to interest rate policy and a “higher for longer” approach does present some problems in terms of messaging, especially when growth is slowing sharply, but when you look at the high levels of services and wage inflation, it’s hard to see how the Bank of England can overlook that, even against the current challenging growth outlook.
Now that energy price inflation has been removed from the headline figures, CPI is back at a more manageable 4.6%, well below last year’s peak of 11.1%, although core prices are still at a high 5.7%.
However, the Bank of England’s biggest concern is wage growth, which is currently at 7.3%, while services inflation is at 6.6%, and appears to be behind some of the dissent on the MPC among those who still want higher rates, although this number has shifted to 3 external members of Catherine Mann, Megan Greene, and Jonathan Haskel.
It will be interesting to see if they drop their dissent in light of this week’s economic data and opt for the status quo today, as markets are already pricing in some rate cuts for next year. They will probably still happen, but they may not come as soon as the markets are currently pricing in, given current inflation levels.
If they do come, they are likely to come well after the ECB starts to cut, given that inflation here in the UK is still over 2% higher than in the EU on an annualized basis.
This is the challenge facing the ECB today, as it was the central bank that raised rates as recently as September, and a dovish pivot today would certainly be an admission that the ECB was wrong 3 months ago.
When the ECB met in October, President Christine Lagarde said that the risks to growth were tilted to the downside, but also that inflation was still too high, although it isn’t now given that the headline CPI for November is now at 2.4%.
At the time, there was no commitment as to whether the ECB was done on the rate hike front, but that has now changed given recent comments from Germany’s Schnabel and France’s Villeroy.
The latest economic data coming out of Europe since June has been dismal and we now know that the ECB Governing Council was surprised at how quickly inflation has slowed.
Aside from the fact that this shouldn’t come as a surprise given the trend in PPI over the past 12 months, some other members of the Governing Council have also admitted that the next rate hike is likely to be in 2024.
That’s not surprising given that the French economy slipped into contraction in Q3 and Germany hasn’t seen much growth this year, so markets are now pricing in rate cuts as early as April 2024.
It was also noteworthy that Villeroy said earlier this month that rate hikes were over based on current data, supporting the view that inflation is returning to target. This is already quite evident as the CPI fell to 2.4% in November from 5.3% just 3 months earlier.
No change in policy is expected, with the biggest challenge for Christine Lagarde today being to convince the market that rate cuts won‘t begin until next summer, given how bad the European economy is already.
EUR/USD – Yesterday’s rebound pushed the pair above the 200-day SMA, opening up the prospect of a move towards 1.0940. Support remains above the 50-day SMA at 1.0720.
GBP/USD – The pair held above its 200-day SMA at 1.2500 yesterday and rallied strongly. A break below the 200-day SMA and 1.2460 signals a broader test of the 1.2350 area. After breaching resistance at 1.2620, the pair could extend towards 1.2720.
EUR/GBP – Breaking higher and heading for 100-day SMA at 0.8640. Support now at 0.8580.
USD/JPY – The US Dollar fell sharply yesterday after running into resistance at 146.60, dropping below 144.70 and below the 200-day SMA at 142.50 and could see a retest of the 140.00 area.
The FTSE100 is expected to open 72 points higher at 7,620.
DAX is expected to open 177 points higher at 16,943.
CAC40 is expected to open 84 points higher at 7,615.
