The re-pricing risk

• Equities rallied in Japan and emerging markets, rising over +2% in sterling terms
• The UK and Europe also rebounded, gaining c.+1.6% and 1.9% respectively

• US equities weakened in sterling terms, falling -0.2%
• US government bonds also weakened, falling -0.6% in dollar terms

After a significant move in December, it is clear that interest rate expectations pose a key short-term risk to market sentiment this year. Following Powell’s December acknowledgement that the timing of rate cuts is “naturally…the next question”, market participants wasted no time in pricing those cuts into asset valuations. On New Year’s Eve, over 150 basis points of cuts were priced in by the end of 2024, equivalent to six standard 0.25% point rate cuts, and notably ahead of the rate setting Federal Open Market Committee’s (FOMC) own forecast for rate cuts.

Since then, the market has been swift to startle, with rate cut expectations being pared back. The release of the December FOMC minutes rattled investors with its more evenhanded language, seen as a contrast to Powell’s dovish tone at the press conference, and the January meeting saw Powell push back more firmly on market pricing.

January’s employment data seemed to justify this push back, with an acceleration in both payroll growth and wage growth. Last week’s inflation print provided a further spur for reevaluation, with inflation falling in January, but by less than expected. Headline Consumer Prices Index (CPI) slowed to 3.1% from 3.4%, but was ahead of economists’ 2.9% forecast, boosted by an acceleration in shelter costs, which make up around a third of the index.

Given the renewed strength in inflation and employment, what should the market expect interest rates to do this year? The US economy is certainly not in collapse, though the longer-term trend in the data does point to an easing in the labour market and a retrenchment in consumer spending. January’s retail sales slowed -0.8% on the month, with downward revisions to November and December data, and further slowing expected over the course of Q1. Slower consumption is likely to lead to softer GDP growth, helping inflation to cool further. However, while market expectations of interest rates look more realistic today than at the end of last year, they could still be somewhat extended, with four hikes priced in, starting in June. Such pricing offers limited wiggle room if growth surprises to the upside in Q1 – which is expected to be the softest period of growth this year.

We continue to expect rate cuts this year, but still see scope for further volatility, as expectations as to the timing and extent of cuts are pared back further.

While key US data has been ahead of forecasts, the picture in the UK has been more mixed. UK inflation remained at 4% in January, below economists’ forecasts and the Bank of England’s (BoE) own estimate, pulled down by softer pricing in travel, household items, clothing and goods. GDP data for December was also softer, with downward revisions to earlier months meaning the economy contracted by -0.3% in Q4. This in part reflects strike action, which hit health output and government spending, but also reflects a -0.1% decline in household spending, on top of a -0.9% decline in Q3.

Alongside this softer print, January retail sales were surprisingly resilient, with volumes increasing by 3.4% after a -3.3% fall in December. This follows January’s labour print, which saw a downward revision to the unemployment estimate, though wages slowed and vacancies continued to decline.

For the BoE, soft data and continued slowing in inflation and wage growth will likely allow a further dovish shift amongst Monetary Policy Committee (MPC) members. We anticipate this manifesting in a further shift in the voting pattern of committee members. However, the true test will be the next Monetary Policy Report in May, when new forecasts will be published based on market based indicators of interest rate expectations. February’s report made it clear that Bank models indicated a need for easing, but not as much easing as the market priced in at the time – around four rate cuts by the end of the year. Today, that pricing has moved closer to three cuts and it may shift further by May.

The UK was not the only economy to experience a contraction at the end of 2023, with Japan also seeing a decline. On a quarter-on-quarter annualised basis, Japan’s economy contracted by -0.4%, after a 3.3% fall in Q3. This saw Japan slip from its position as the world’s third largest economy.

Behind the weakness was soft domestic demand, including a -0.9% annualised decline in consumption over the quarter, and a -0.3% fall in private capex.

This soft print comes at a time when the Bank of Japan (BoJ) is looking to exit its extraordinary easy monetary policy and finally begin raising interest rates. The market expects this to happen imminently. However, confidence in the strength of the economy, and the sustainability of inflation and wage growth, now comes into question.

We expect the BoJ to take a phased approach, adjusting forward guidance first, then relaxing the Yield Curve Control policy, and later exiting negative rates.

Important information
The information contained in this article is believed to be correct but cannot be guaranteed. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall as well as rise and is not guaranteed. An investor may not get back the original amount invested. Opinions constitute our judgment as at the date shown and are subject to change without notice. This article is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Where links to third party websites are provided, Close Brothers Asset Management accepts no responsibility for the content of such websites nor the services, products or items offered through such websites.