14 December 2023: Rates to remain at a fifteen-year high

The economy failed to build on its expansion at the end of the third quarter by contracting by 0.3% in October. The monthly growth figures, which were published yesterday, disappointed the market and set the economy firmly on a path towards a recession.

With interest rates at a fifteen-year high designed to dampen demand and bring inflation under control, any growth will be hard to come by in the coming quarters.

The monetary policy committee meets today and is almost certain to leave interest rates unchanged. Although the latest GDP data was worse than expected, it is unlikely to influence the Committee, which is committed to bringing inflation back close to the Government’s 2% target.

Having paused its cycle of rate hikes at its September and November meetings, there has been nothing yet to indicate the major change in policy that would be necessary for rates to be amended.

The vote at the most recent meeting was 6-3 in favour of a pause with Sarah Breeden, replacing Jon Cunliffe, voting for the status quo, where Cunliffe voted for a hike at his final meeting in September.

While the Labour Party supports the independence of the Bank of England, indeed it was Gordon Brown, as Chancellor, who created the MPC, it is likely that should it win the General Election that is expected to be held next year changes will be made to make it more representative.

The current number of permanent members creates a feeling of “groupthink” in which Andrew Bailey’s subordinates vote in accordance with his expectations.

A vote to maintain rates at their current level will prolong the agony for thousands of households who have seen their mortgage payments rise significantly over the course of this year as their fixed rate deals came to an end, leaving them exposed to floating rate payments.

This is the true essence of the conscious decision to dampen demand. The hikes have had a more radical effect on the housing market than employment, where the claimant count is slowly rising, but not by the amount that the market may have expected.

The Bank of England will need to be wary of the conditions that it itself is fostering if it is not to contribute to a recession in the coming months.

The pound rallied late yesterday as Jerome Powell agreed that the Fed will not need to hike rates further. It rallied to a high of 1.2634 closing at 1.2627.

It has continued on the front foot in Asia.

Jerome Powell finally accepted the inevitable yesterday at the beginning of his press conference following the decision of the latest meeting of the FOMC to leave interest rates on hold.

He told assembled journalists that “it is not likely we will hike further”. While this has been fairly obvious for some time, to hear the words from the mouth of the normally hawkish and reserved Chairman of the Federal Reserve took the market by surprise.

He went on to acknowledge that the economy is seeing strong growth while inflation has retreated over the past few months, although they still have a way to go, and it would be premature to declare a victory.

So far, FOMC members are not seeing any signs of a coming slowdown in activity, while a recession does not feature in the Fed’s base case.

The FOMC believes that it has done enough on rates but is not fully confident of that view yet.

Powell was more dovish than of late, commenting that it is unlikely that the Central Bank will wait until inflation has fallen to its target of 2% before cutting rates. He believes that it would be too late by then.

The size of the Fed’s balance sheet is close to where the Committee wants it to be, which means that there is no necessity to amend the size of Quantitative Tightening currently, although that remains under constant review.

Overall, this was the FOMC’s first dovish pause, and the market reacted accordingly.

The Dow Jones Index rallied significantly, while the dollar lost ground as traders increased bets on the Fed being the first G7 Central Bank to cut rates.

The dollar index fell to a low of 102.77 and closed at 102.95. It has continued to lose ground in Asian trade, so far (0500 GMT) reaching a low of 102.42.

Having broken through medium term support, it is likely that the Index will trade in a lower range for the rest of the year, unless the ECB is similarly dovish at its meeting later this morning.

With inflation continuing to decline and the economy posting robust growth figures, it does seem that an elusive soft landing is very much possible. This will provide President Biden with a significant boost as he heads into an election year.

The market doesn’t expect Christine Lagarde to follow Jerome Powell’s lead by making similar dovish comments when the latest meeting of the ECB’s Governing Council concludes later this morning.

She is surrounded by a majority of Central Bankers who continue to be hawkish over the prospect of inflation reigniting. Despite that, even they must concede that prices have fallen faster than even they imagined,

If they acknowledge that fact, it may be confirmation that at least the final rate hike was a “bridge too far”.

Lagarde may change her rhetoric slightly and confirm that the timetable for rate cuts was discussed, although it is unlikely that she will say anything more substantial than that.

There remains a difference of opinion between the market and the ECB about the timing of the first cut. The Central Bank sees the first cut coming at the start of the third quarter, if necessary, while the market, based on economic performance, believes that it will be forced to cut as soon as the first quarter.

Central Banks never want to be forced into action since it calls into question the reliability of their projections, but neither do they wish to be seen as stubbornly sticking to beliefs that are clearly incorrect, so there may be a clue offered by Lagarde later this morning.

Data certainly continues to show that a rate cut may be necessary sooner rather than later.

Yesterday’s publication of industrial production showed that output fell to a three-year low. Calendar and seasonally adjusted figures fell by 0.7% following a 1% fall in October.

Production of both capital goods and consumer non-durables fell to lows not seen since the end of the Pandemic.

Ireland, Malta, and the Netherlands saw the biggest falls, while there were marginal improvements seen in Greece and Portugal.

At today’s meeting, a lot will depend on how strong the Governing Council feels it can be in pushing back against calls for rates to be cut.

An overly hawkish view will be seen as naive since it will portray an almost King Canute-like refusal to accept the inevitable, while anything overly dovish may portray the feeling that the ECB is content with the current level of inflation.

The euro saw a significant rally following the FOMC meeting yesterday. It rallied to a high of 1.0896 and closed at 1.0891.

It remains to be seen how many short positions have been washed out and whether traders have any desire to establish new ones this side of the end of the year.

Have a great day!