Lower interest rates lie ahead

Western central banks have tried to lower expectations of rate cuts, but the trend this year will be down. But when will borrowing costs start to fall.

| 4 min read

Data from the US – with employment doing well and wages still strong – made markets worry that rate cuts might come later and be less frequent than the market's bullish expectations. The Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE) all tried to play down the idea of early rate cuts, pointing to remaining inflationary forces visible in wages. Service sectors are the dominant part of these economies, so wage increases running well above the inflation target of 2% is a concern to the central banks.

There are also worries about supply interruptions and higher costs of transport for goods and components, given the Houthi attacks on Red Sea shipping. So far, this has not caused undue rises in the oil price, but it is adding to freight costs as more goods are diverted to longer routes. This both increases the cost of any given journey to pay for extra days at sea – and raises shipping rates by occupying capacity for longer to complete any given task.

Rates fall, despite sticky inflation

Nonetheless, there is plenty of evidence that most central banks will be cutting rates this year. Some have started already. Argentina has come down from 126% to 100%. The new president is setting about the task of cutting public spending and borrowing to curb monetary and fiscal excess. Brazil has cut from 11.75% to 11.25% as its inflation and money growth improves. China has been relaxing in small steps, covering a variety of means of easing, for many months. This included taking rates down 0.1% to 3.45% in the latest move. Israel, Poland and the Czech Republic have made their first 0.25% cut, whilst Chile is down by one percentage point and Hungary 0.75 of a percentage point from their peaks. We can expect more from a variety of central banks.

Money growth has fallen in the US and Europe. This followed the surge in money growth recorded as part of the response to the covid lockdowns and continued to foster more rapid recovery. The Fed, the ECB and several other advanced country central banks created plenty of money to buy up state bonds. The idea was to raise the price of the bonds to lower the interest rates for governments to borrow at. This fostered an expansion of borrowing and was the background to the inflationary pressures.

The monetary squeezes have helped bring inflation down on both sides of the Atlantic.

China did not undertake quantitative easing and big bond buying during its long period of lockdown – and did not get the same inflation as the West. Japan continued with its quantitative easing bond purchases at similar levels to pre-Covid days, which kept its money supply growth more constrained than the Fed or ECB. Japanese inflation peaked at 4% rather than around the 10% experienced in Europe and the USA. India has maintained money growth throughout and has sustained better GDP growth.

The monetary squeezes have helped bring inflation down on both sides of the Atlantic. In Europe, it has also stalled the economy. US growth has been good, in part thanks to a large offsetting fiscal stimulus. US success also owes much to the strength of its digital sectors. Japanese growth has improved a bit from a slow performance. Chinese growth has only recovered to around 5%, slow by its pre-Covid standards. This reflects the decision to deflate the runaway property sector which has boosted past performance.

Bond yield spreads

Ten-year bond yields are now spread out from Japan's 0.7% through China and Germany at less than 2.5% to the US at 4% and India at 7%. US yields have been driven up more by aggressive selling of bonds by the Fed from its own portfolio, coupled with the pressure from higher short-term rates.

We maintain our view that we will see reasonable world growth this year, with falling inflation and interest rate cuts in many of the advanced economies. The market is adjusting expectations of rate falls to take account of the US and European caution over the speed of the changes. The central banks want to be sure inflation is under control. The direction of travel is clear, with other countries now leading the way to lower rates.

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Lower interest rates lie ahead

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