A big disconnect between financial markets and central banks has just got deeper, with traders ramping up their bets on interest rate cuts in the United States, Canada and Europe as evidence grows that inflationary pressures are fast abating.
Money markets are now pricing in at least 100 basis points apiece of rate cuts from the U.S. Federal Reserve, the Bank of Canada and European Central Bank next year, and have this week shifted the expected timing of their first moves firmly forward into the first half of 2024.
It’s not hard to see why traders are ready to leave behind the most aggressive rate-hiking cycle in decades.
Euro zone inflation tumbled far more than expected in November, data on Thursday showed, a challenge to the ECB’s narrative of stubborn price growth.
In the United States, the Fed’s preferred inflation measure, the core PCE price index, eased in October.
Canada reported Thursday that real gross domestic product fell at an annualized pace of 1.1 per cent in the July-to-September period – considerably weaker than the Bank of Canada’s estimate of 0.8-per-cent growth and Bay Street’s expectations of a slim 0.1-per-cent increase.
For much of this year central banks have successfully pushed back against rate-cut bets.
But this week’s price action suggests that task could get harder as investors question whether the mantra of higher rates for longer can hold if inflation keeps easing quickly.
“Is the Fed going to pivot from their hawkish statements that they are adamantly focused on inflation and need to kill it?” said Nate Thooft, global CIO for the multiasset solutions team for Manulife Investment Management.
“I believe the Fed will act rationally and begin to cut rates by the end of next year, but we can’t rule out the scenario that the Fed is not going to cut rates and just let the ramifications of recession do what they do.”
Markets now fully price in a 25 basis point U.S. rate cut in May, having seen a 65-per-cent chance earlier this week. Just a few weeks ago, a first cut was seen in June.
Bets for a March cut have also shot up, with traders pricing in nearly a 50-per-cent chance, versus 35 per cent earlier this week.
That trend is also being seen in Canadian money markets. Implied probabilities in swaps markets as of Thursday afternoon suggested slightly better than 50-per-cent odds the Bank of Canada will make its first rate cut in March, according to Refinitiv Eikon data. By June, credit markets are assigning a greater than 90-per-cent chance the bank’s overnight rate will be lower than it is today.
Adding to the pressure on the Bank of Canada, the C.D. Howe Institute said on Thursday that its Monetary Policy Council – made up of 12 top financial market and monetary economists – is recommending the bank cut its overnight rate by 100 basis points – to 4 per cent – by the end of 2024. It recommends the first cut should come by June.
The recommendation reflects the median vote of the council’s members, which includes the most senior economists with the Bank of Montreal, RBC and CIBC. By December of 2024, all members called for a lower overnight rate, with the recommendations ranging between 3.50 and 4.50 per cent.
“The group was satisfied that excess demand in the Canadian economy is dissipating – the national accounts numbers for the third quarter of 2023 showed widespread weakness in private-sector activity, notwithstanding rapid population growth – and that forward-looking indicators such as consumer credit and the monetary aggregates are signalling further weakness and continued declines in inflation,” said a statement from the Toronto-based think tank.
All this creates a headache for policy makers across the developed world, as the speed of the bond and stock rally prompted by those changed expectations loosens the financing conditions they have been trying to tighten by raising rates.
U.S. Treasury yields are down more than 50 bps in November, the biggest monthly fall in over a decade.
A Goldman Sachs U.S. financial conditions index has eased 90 bps over the last month to its loosest since early September.
The bank has in the past shown a 100-bps loosening boosts growth by one percentage point in the coming year.
But for many, the fast fall in inflation means central bankers may shift closer to market thinking, as they did in 2021-2022 when investors challenged their “transitory” inflation view as price pressures surged.
Comments this week from U.S. Federal Reserve policy maker Christopher Waller, a hawkish and influential Fed voice, that he was increasingly confident inflation would return to its 2 per cent target, has fuelled rate-cut bets.
In early November, Bank of England chief economist Huw Pill said mid-2024 might be time for cuts, a view also expressed by Greek central banker Yannis Stournaras.
“There are now committee members in all three [banks] willing to talk about rate cuts next year,” said Chris Jeffery, head of rates and inflation strategy at LGIM.
“Previously we’d had a stone wall of: higher for longer Table Mountain, rates need to stay in restrictive territory.”
Some analysts, like Deutsche Bank’s, are forecasting even swifter cuts than markets.
“Central banks will probably pivot quicker than people think, and probably harder, and inflation [trends] basically give them the opportunity to do that,” said Dario Perkins, managing director of global macro at TS Lombard.
Traders now fully price a 25 bps ECB rate cut in April. In late October, they expected a first cut in July.
Thursday’s data showed euro zone inflation dropped to 2.4 per cent in November from 2.9 per cent in October, nearing the ECB’s 2-per-cent target.
Simon Harvey, head of FX analysis at Monex Europe, said recent weak data suggested that euro area monetary policy is too tight and has induced a recession.
“The ECB should begin to ease policy as soon as April, 2024, with risks that a more sinister downturn in growth could warrant a rate cut as soon as March,” he said.
With files from Darcy Keith of the Globe and Mail
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