Over the past ten days, US rate expectations have swung massively from ‘higher for longer’ to ‘rate cuts in May 2024’. For Europe, consensus has moved even faster, with March now being priced in for the first rate cut. Long-dated bonds have followed suit, with yields dropping markedly as well. ‘Overblown’, you may say, and indeed, the swings on the boom/bust scale have been breathtaking so far. Yet we feel confirmed in our view that mid-October 2023 marked the top in bond yields and that the end of October marked the low in equity markets for the foreseeable future (as outlined by us two weeks ago).
Policy rate expectations: Pricing in the victory over inflation
A noticeable slowdown of inflation in the US and the eurozone has triggered a reset of policy rate expectations. Financial markets are pricing in that the US Federal Reserve (Fed) and the European Central Bank (ECB) will declare victory over inflation. Inflation in the US is moving closer to 2% with the headline rate at 3.2%, the core rate at 4%, and the super-core rate that excludes food, energy, and shelter at 2%.
The same is true for the eurozone: headline inflation is at 2.9%, core inflation is at 4%, and the trend inflation is at 2.5%. At the same time, both central banks are cautious in declaring victory over inflation and in confirming the notable shift in market expectations regarding the path of interest rates.
The Fed is now expected to start cutting rates in May 2024 by 75bps–100bps in 2024 from the current target range of 5.25%–5.5%. For the ECB, markets also expect rate cuts of 75bps–100bps in 2024 starting already in March 2024. The adjusted interest rate expectations provided a considerable tailwind for risky assets, which is now largely exhausted. Lower inflation alone will hardly convince the Fed to start cutting rates as early as currently priced in for 2024.
Given the still decent economic growth that is expected to cool further in 2024 and lead to a soft landing, we stick to our expectations that the Fed will start lowering rates only in September 2024 and just by 50bps in 2024. The eurozone is already facing a challenging economic backdrop and has more difficulties to deal with the high level of interest rates. We therefore adjust our ECB rate outlook by expecting the first rate cut in April 2024 and an overall reduction in the policy rate by 75bps in 2024.
What does this mean for investors?
On the investors’ side, yet another buying opportunity in risk assets has gone, with most investors sadly missing out. Looking at our sentiment gauges, the bounce has been sizeable indeed. In fact, given where fundamentals stand today, one can already see some signs of exuberance, which is quite the change given the broad-based desperation witnessed only six weeks ago.
From this point on, the year-end rituals of the financial industry will likely rule into early 2024. This translates into a lot of trend following, as the winners of 2023 will prevail in the window-dressing exercise that the large institutional investors perform in the final innings of the year. That said, some final contrarian trades can be made before that. For instance, European utility stocks, with the support of fundamentals, could continue to recover after a dreadful stretch.