Interest rates are set to go lower

The UK lowers interest rates

• The UK’s Monetary Policy Committee (MPC) has lowered interest rates. Interest rates are now set at 5%, after being held at their peak of 5.25% for the last twelve months. The MPC members voted five to four, in favour of the cut in interest rates.
• The MPC has become increasingly confident that inflation is sufficiently contained, allowing it to lower rates, and thus to ease the burden on the economy.
• Davy have been expecting this move, even though the market appeared to only price the chances of a rate cut at 50/50. We suspect that the first cut would have come in July, had the UK not been in the midst of a general election.
• UK inflation has fallen back to the 2% target, bolstering confidence that inflation is now under control.
• This interest rate cut follows cuts from central banks across Europe, Canada, Switzerland and Sweden in recent weeks.
• At their 31st July meeting, the US Federal Open Market Committee (FOMC) gave their strongest indication yet, that their interest rate cutting cycle in the US will begin in September 2024.
• All major central banks are all expected to make additional cuts this year. Figure 1 below illustrates that the UK MPC is expected to lower rates an additional two times to 4.5% by year end, with additional cuts expected into 2025.

Figure 1: The end of an aggressive and swift interest rate hiking cycle

Source: Bloomberg as of 01/08/2024

A look at other major central banks

• The ECB is in a similar position to the UK MPC. The ECB will allow for inflation to run slightly hotter than their 2% target also, as shown in their July staff projections for slightly higher inflation in 2025. This will be the trade-off to the macroeconomic benefits of allowing for a cyclical upswing in growth. The ECB was the first to cut rates of the major central banks and remains on course to continue to loosen monetary policy from restrictive levels.
• The FOMC offered its most significant indication that it will likely start to reduce interest rates in September. This view is taken from their renewed focus on the balancing of risks between inflation and the labour market. The US labour market will be in focus as markets grapple with any potential for deterioration. Markets are now expecting three interest rate cuts in 2024, so room to expect more in 2025 remains very possible.
• The Bank of Japan (BoJ) are taking the counterview to most major central banks. The BoJ took its policy rate out of negative territory in March and subsequently ‘increased’ interest rates by a further 0.15%, to bring its policy rate to +0.25% at their July meeting. Attempts to normalise its long standing ultra loose policy and bring stability to its weak currency coincide with softening economic data in Japan which may limit the extent of future rate increases.

Figure 2: Inflation has come back under control

Source: Bloomberg as of 01/08/2024

Market reaction

• Sterling experienced weakness running over the last week in anticipation of the rate cut but has since stabilised.
• Pressure on sterling was alleviated from enhanced expectations of interest rate cuts in the US FOMC and from the European Central Bank (ECB).
• Sterling was also buoyed from cautious MPC rhetoric on the speed and timing of any further cuts, with a lack of clear commitment to future easing.
• Furthermore, MPC forecasts offered a positive economic environment, with inflation forecast to remain at target whilst growth was revised upward for H2 2024 and 2025.
• There have been signs of a cyclical macroeconomic upswing from the UK 2023 economic malaise. In 2024, business surveys have continued to improve from low levels, coupled with a rejuvenated consumer buoyed from a growth in real wages.
• Trade-offs are to be expected between a cyclical upturn in the UK and growth prospects, and the melioration of inflation.
• We remain favourable to sterling and the euro versus the US dollar, expecting the US dollar to experience pressure in the coming months.
• Bonds have been rallying, pushing yields lower again. The prospect of ‘higher for longer’ rates is eroding, which is evident from bond market rallies across the US and Europe. Furthermore, bonds are buoyed from confidence in a diminished inflation threat, the start of the interest rate cutting cycle and geopolitical developments.
• Sentiment has improved over recent months in the UK, with some expecting the new government to offer a fresh lease for the UK. UK equity valuations remain cheap relative to Europe and the US, offering potential catalysts for excess returns going forward.

Figure 3: Sterling Rallying

Source: Bloomberg as of 01/08/2024

Davy’s view

• The potential for unintended consequences for central banks remains high. Currently, inflation remains sticky in Europe and the US, employment is yet to show significant cracks, wage growth is elevated, equity markets at (almost) highs, and growth is stable and/or improving.
• It is positive that the UK faces potentially stronger-than-anticipated economic growth, benign inflation with real wage increases. Taking this into account, some argue the risks of stoking inflation again, outweigh the need for cuts. However, with interest rates at 5.00%, they remain in restrictive territory, and the magnitude and pace of monetary easing still remains unclear. Expectations to the magnitude and pace of interest rate cuts will morph with the market environment and economic trajectory.
• On the other hand, some market participants have started to consider the potential for an economic downturn, driven primarily from sentiment and broad economic data from the USA. However, bond yields will fall in response to this, and all major central banks have significant ammunition to reduce interest rates and increase balance sheets considerably.
• On balance, this leads us to expect the pace to be measured but do believe that the UK MPC remains on course to continue to loosen monetary policy by lowering interest rates.
• They are likely to exhibit flexibility in their 2% inflation target, the outcome of which is that they will have a tolerance for inflation running slightly higher, as a trade-off to the macroeconomic benefits of an upswing in growth.
• Interest rate and hence the return from cash will likely continue to head lower. Cash returns tend to lag bonds and equities after interest rates peak. Interest rates and bond yields are set to go lower, which will in turn prove to be constructive for equity and bond markets going forward.

Figure 4: Bonds and Equities tend to outperform Cash after the interest rate peak

Source: Bloomberg as of 31/07/2024

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