Another higher-than-expected US inflation number means the US Federal Reserve should be in no rush to cut rates before price pressures subside. With the risk of inflation continuing to surprise to the upside in the near term, we now expect benchmark 10-year yields to potentially retrace to 4.75%, at which point we would likely again go overweight duration.
The prospect for higher energy prices, higher Treasury yields, geopolitical tensions ratchetting up, and a US presidential election where the Republican candidate is proposing a series of inflationary policies makes us keep a long position in breakeven inflation.
In the eurozone, the case for rate cuts looks compelling. We expect the ECB to deliver its first 25bp cut in June, followed by two to three cuts in the second half of 2024, lowering the deposit rate to 3.00-3.25% by the end of the year.
US – A new quarter, a new outlook
Beginning-of-the-year prospects for up to seven Fed rate cuts by the end of the year have morphed into expectations that inflation will remain sticky, growth robust, and suspicions the Fed might cut rates only twice (or less) by the end of the year.
We expect the strength of the March payrolls report and higher-than-expected CPI inflation to prompt Fed officials to question whether the central bank’s policy stance is in fact ‘very restrictive’ and prompt reminders that the Fed is in no rush to begin rate cuts.
Despite strong momentum in hiring in March, a growing labour force, and wage pressures remaining above the Fed’s comfort zone, our baseline view is for a rebalancing labour market. The risk is that rising real wages, solid consumption, and easy financial conditions could stall this rebalancing and halt progress on services disinflation.
Recent inflation data means the risk of higher and persistent underlying inflation is now the Fed’s number one priority, even though inflation is not that far above target.
The real challenge for the Fed is non-housing services inflation (commonly called “supercore”). The trend in this component, which is the largest in the PCE basket, should worry the Fed. On a six-month annualised basis, supercore inflation is running at above 6%
Correspondingly, with the risk of inflation continuing to surprise to the upside in the near term, we expect 10-year yields to potentially bounce to 4.75%, at which point we would likely again go overweight duration.
On breakeven inflation (BEI), besides the CPI data, we are watching energy prices closely, with the US looking to rebuild its strategic petroleum reserve at the same time as tensions between Israel and Iran are rising.
The prospect for higher energy prices, higher Treasury yields, and growing geopolitical tensions heading into a presidential election where the Republican candidate is proposing a string of inflationary policies — including an immigration clampdown and tariffs on foreign imports — keep us long BEIs.
Eurozone – Expect a steeper yield curve
With the economy stagnating over the past few quarters and wage growth moderating, the risks of a wage-price spiral have largely receded. In the absence of an easing in monetary conditions, real policy rates would become increasingly restrictive and raise the risks of inflation undershooting the ECB’s 2% inflation target.
At the same time, sentiment indicators have improved. While advancing disinflation should comfort the ECB and allow it start easing policy rates, resilient economic data alleviates the need for aggressive easing.
We expect rate cuts to lower the deposit rate to 3.00-3.25% by the end of the year in line with President Christine Lagarde’s comments that the cutting cycle may be gradual. At the time of writing, front-dated interest rate pricing implied a deposit rate of around 3% by end-2024, and 2.4% by end-2025.
We see both upside and downside risks to the policy path currently priced.
On one hand, the drag from past monetary tightening is expected to ease. Disinflation has started to lift household purchasing power, providing a tailwind to economic growth. If inflationary pressures prove stickier during the ‘last mile’ of inflation falling, the ECB may not need to cut policy rates by as much or as quickly as priced in the markets.
On the other hand, the fiscal stance is beginning to tighten as energy subsidies have ended, and EU fiscal rules return to focus in the second half of the year. While we do not expect fiscal austerity to return, an easier monetary policy stance might be required to balance the negative impact from tighter fiscal conditions.
We expect the yield curve to steepen and believe front-dated yields should outperform as the ECB edges closer to rate cuts. At the same time, long-dated bond yields remain vulnerable to a potential rise in term premium as the bond issuance needs of euro governments are still historically high and price-insensitive purchases from central banks are coming to an end.
In country selection, we are neutral towards Italy, but overweight in Spain and Germany against France. We expect Spain to outperform core countries when it comes to growth as the services sector remains dynamic and investment flows from Next Generation EU funds support growth.
Italy should also benefit from NGEU funds, but it has accrued significant fiscal costs under the ‘superbonus’ tax credit scheme; curbing these tax incentives will drag on growth and lower tax revenues will weigh on the debt burden. These factors present significant headwinds to Italy’s debt-to-GDP ratio in the near term, which could in turn become a drag on government bond performance.
UK – Next step: rate cuts
The economy should be on track for modest growth in the first half of 2024. The second consecutive two percentage point cut in National Insurance contributions, lower utility bills and the scheduled 10% increase in the National Living Wage should put cash back into consumers’ pockets and support consumption.
In addition to the rise in real income, with household savings rate now standing at around 10%, any normalisation in savings could drive spending. The recovery will likely still be modest. Interest rates will remain restrictive in 2024, which should depress output. Despite the personal tax cuts, fiscal policy is expected to tighten by around 0.7% of GDP.
CPI headline inflation is on track to fall below 2% in the spring. Weaker energy, food and core goods inflation has contributed to the disinflation. More is in the pipeline as the energy price cap is reset lower in April and July and surveys point to a continued drop in food inflation.
Services inflation, however, has been more persistent at 6.1% year-on-year. In the near term, administered and index-linked prices and robust wage growth will keep services CPI sticky.
The outlook for the labour market and implications for inflation look uncertain.
On one hand, at 3.9%, the unemployment rate is well below the Bank of England’s estimate of the non-inflationary equilibrium level of 4.5%. A higher National Living Wage is likely to lead to higher services inflation.
On the other hand, the decline in job vacancies and rise in redundancies could be the harbinger of a broader decline in companies’ appetite for workers and would lead to a rise in unemployment.
In the long term, we remain of the view that the impact of Brexit, labour market scarring left by the pandemic, and years of weak business investment have led to supply-side constraints which, in turn, weigh on the economy’s growth potential.
There are nonetheless factors that could drive UK yields above their long-term fundamental values: net Gilt issuance remains at historical highs and the central bank’s quantitative tightening has removed a large, price-insensitive buyer from the Gilt market. Similarly, pension funds now enjoy a much stronger funding status and hedge ratios such that their liability-driven activity, which was a major source of demand for index-linked Gilts, has declined meaningfully.
The experience of the ‘mini budget’ debacle in 2022 is still in the collective memory of investors, and while the current government has limited its fiscal splurge to within the headroom available, uncertainty about the UK’s long-term fiscal outlook ahead of a general election will likely keep foreign investors cautious.
This mix of heavier issuance, central bank balance sheet reduction, and changing investor demand led to a significant increase in term premia in 2023 and the theme of higher term premia could return in 2024. Currently, the government is forecast to nearly balance the books if growth picks up, inflation and interest rates fall, and substantial cuts are made to unprotected public spending.
If these factors fail to materialise, or public spending cuts prove politically difficult, the framework of fiscal prudence will be challenged.
The debate at the BoE has already shifted from keeping the Bank Rate on hold to lowering the degree of policy rate restrictiveness. Headline inflation is projected to fall to 2% in the spring, and various indicators point to a continued moderation in wage growth. These should give policymakers some confidence that monetary policy is working to bring inflation back to target sustainably.
We expect the BoE to begin cutting interest rates in June, followed by two quarterly 25bp cuts, taking the Bank Rate to 4.5% by end-2024. Thereafter, we expect further normalisation of wage growth and services inflation. If this materialises, we expect the BoE to deliver faster rate cuts in 2025 to return the Bank Rate to a neutral level, which we estimate to be at around 2.5%.
