Ease on down the road

Market recap

• The global economy demonstrated overall strength, although some regions were impacted by the aggressive policies of central banks. While inflation rates were decreasing, a return to normal levels was expected to be a gradual process.
• US Federal Reserve (Fed), the Bank of England (BoE), and the European Central Bank (ECB), among other key central banks, were nearing the end of their strict policy phases. It was expected that they would maintain interest rates for several periods before starting a slow reduction phase. Europe's growth was comparatively lower than that of the US, partly because European households had less savings to offset the impact of high inflation.
• The expected change in monetary policy, moving from prolonged high-interest rates to potential rate reductions, significantly influenced the end of 2023. As a result, there was a noticeable decrease in government bond yields in major economies such as the US, UK, and Europe.

2024 outlook

• The Fed has signalled its intention to lower its key rate to around 3.75% by the end of 2024, with a further decrease to around 3% by the end of 2026 before rising again.
• Economists forecast that the ECB will begin reducing interest rates from March 2024. This is due to the expected decrease in borrowing costs caused by a decline in inflation rates.
• Both the ECB and the BoE are adjusting their monetary policies in response to the changing economic conditions, particularly in relation to inflation rates and economic growth. The exact timing and extent of the rate cuts will depend on the evolution of economic indicators throughout the year.

In Q4 2023, there was a notable decrease in inflation, along with signs of economic stability or a slight recovery. As a result, market expectations for rate cuts increased and advanced rapidly. The Eurozone's annual inflation rate went up to 2.9% in December 2023, up from 2.4% in November. 

In December, the core Consumer Price Inflation (CPI), which excludes volatile items such as food and energy, dropped to 3.4%, the lowest level since April 2022. These figures indicate a significant reduction in inflationary pressures in the region.

In Q3 2023, the Euro area's Gross Domestic Product (GDP) contracted slightly by 0.1%, following a modest 0.1% increase in the second quarter. The revised GDP growth projections for 2023 are now at 0.6%, which is further expected to decrease to 0.8% in 2024, with a stable projection of 1.5% for 2025. This revision reflects the impact of tight financing conditions, a tightening in credit supply conditions, and their effects on investments and consumption.

The Eurozone PMI was revised slightly in December 2023,from the initial estimate of 47.0 to 47.6. However, this revision still indicates that the Eurozone economy is contracting. Both the Manufacturing Output and Services Business Activity PMIs remain below the 50 mark, suggesting economic contraction.

In December 2023, the ECB decided to maintain its existing monetary policy stance, keeping the key interest rates unchanged. The rates for main refinancing operations, marginal lending facility, and deposit facility remained at 4.50%, 4.75%, and 4.00% respectively.

The ECB's decision was based on the belief that the current interest rates, if maintained for a sufficient duration, will substantially contribute to achieving its 2% medium-term inflation target. The ECB's decision was influenced by the expectation that inflation, despite decreasing in recent months, is likely to decline gradually and approach the 2% target by 2025. Underlying inflation has eased, but domestic price pressures remain high, primarily due to strong growth in unit labour costs. The ECB predicts subdued economic growth in the near term but expects recovery due to rising real incomes and improving foreign demand.

Although the peak of inflation is behind us, a significant portion of the impact of monetary policy has yet to be realized, continuing to put downward pressure on economic growth.

In the 12 months leading up to November 2023, CPI decreased by 3.9%. This represents a decrease from the 4.6% recorded in October and a significant drop from its recent peak of 11.1% in October 2022.

In December 2023, the UK services sector grew faster than expected with Services PMI climbing to 53.4, surpassing both the November figure of 50.9 and the preliminary estimate of 52.7. This marks the second consecutive month of expansion, which is a positive sign compared to the contractionary trend observed in the Eurozone. The growth can be attributed to an increase in new orders, indicating a resurgence in consumer demand, particularly in the financial services and technology sectors. However, the sector also experienced higher input cost inflation since August, which led to subdued hiring and higher output charges. Despite ongoing challenges such as cost-of-living pressures, tighter household budgets, and the BoE’s restrictive policy stance, optimism regarding business conditions for the coming year reached a seven-month high.

According to the latest estimates, monthly GDP fell by 0.3% in October 2023, after growing by 0.2% in September 2023. The GDP growth for Q3 2023 was -0.1%, indicating a slight contraction.

In Q4, the Monetary Policy Committee (MPC) decided to keep the Bank Rate at 5.25%, citing various economic factors. The MPC acknowledged that the current monetary policy was restrictive, given the significant increase in the Bank Rate since the start of the tightening cycle. The Committee aimed to monitor ongoing inflationary pressures and the economy's strength. They anticipated a rapid decline in CPI inflation and expected it to stand at around 4.75% in Q4 2023, 4.5% in the first quarter of 2024, and 3.75% in the second quarter of 2024. The MPC's ultimate objective was to sustainably bring inflation back to the 2% target.

Projections suggested a return to this target by the end of 2025. The Committee also mentioned that monetary policy might need to be restrictive for a prolonged period and that further tightening might be necessary if signs of more enduring inflationary pressures emerged.

The focus has shifted in the US market as the Fed has reached terminal rates and investors await a potential easing.

In Q4, there was a gradual and interconnected shift in the U.S. financial landscape regarding monetary policy, market dynamics and Treasury activities.

In October, there was a growing inclination among policymakers to pause interest rate hikes, as indicated by the minutes from the September Federal Open Market Committee (FOMC) meeting. This sentiment suggested a possible break in the tightening cycle in November, signalling the first consecutive pause. During this period, there were increased geopolitical tensions and a decline in market expectations for a year-end rate hike from 50% to 25%. At the same time, the U.S. Treasury escalated the issuance of Treasury securities, with a significant rise in both bill and coupon issuance, marked by a spike in the Secured Overnight Financing Rate (SOFR).

In November, the FOMC meeting maintained the federal funds rate at 5.25%-5.50%, reflecting a dovish shift in the committee's stance. This was in line with slowing U.S. manufacturing and employment data, leading to a substantial bond market rally under the belief that the steady rate might signify the end of the aggressive tightening cycle. Despite another $200 billion increase in Treasury bill issuance, strong demand in the money fund complex absorbed this supply without significantly impacting yield levels.

In December, the FOMC held the rate steady for the third consecutive meeting. The updated economic projections suggested a more pronounced pace of rate cuts by the end of 2024, influencing a rally in longer-term fixed-rate securities and further inversion of the yield curve. The Treasury's rate of bill issuance slowed down compared to previous months, signalling a shift in pace.

Although the overall inflation rate is decreasing, the core inflation rate, which excludes items that are prone to fluctuation such as food and energy, continues to remain high and surpasses the Fed’s target levels. This persistent core inflation is partly due to the continuous growth in wages within the service sector. In terms of headline inflation, as demonstrated by the CPI, there has been a small rise of 0.1% on a seasonally adjusted basis, following a stable rate in October. Over the past year, the all-items index has increased by 3.1% before seasonal adjustment, which is consistent with the predictions made by economists.

The US jobs report for December has shown impressive results, exceeding expectations. Non-farm payroll additions amounted to 216,000, which was higher than the predicted 175,000. The private sector also saw a significant increase of 164,000 jobs, surpassing the forecasted 130,000. 

Despite expectations of the unemployment rate rising to 3.8%, it remained steady at 3.7%. Moreover, wage growth was stronger than anticipated, with a month-on-month increase of 0.4% and a year-on-year rise of 4.1%, surpassing the predicted figures of 0.3% and 3.9%, respectively.