24 Rate Easing Reduced and 2025 the Same

   Figure 1: Policy Rate Cuts Discounted (%)

Source: Bloomberg/Continuum Economics

The first two months of 2024 have been dominated by a scaling back in market implied easing expectations, with thoughts of a 150bps of Fed easing in 2024 having been curtailed to close to four 25bps cuts (Figure 1).  In a similar vein, 2024 ECB rate cut expectations have been dialled back from 150bps to just over 100bps cumulatively, while the BOE is now expected to deliver 75bps instead of 150bps.  

Nevertheless, financial market have not reduced 2025 easing expectations, which remain as envisaged in early January and this has helped wider sentiment in risk and equities, despite the moderate back up in government bond yields.  This is due to a number of reasons.

1.       Weak trust in forward guidance.  Financial markets have a degree of scepticism around DM central banks forward guidance, with the counterargument that central banks will only signal a rate cut shortly before it is delivered.  Additionally, Fed, ECB and BOE officials have not pushed back aggressively against the idea of easing starting in 2024, especially with weak growth in the EZ and UK.  Restrictive policy has worked to get inflation moving back towards inflation targets, it just that central bank officials want to see more progress before getting fully comfortable.

2.       EZ and UK inflation below 2% by Q2.  Additionally, some forecasters including Continuum Economics are arguing that EZ and UK inflation will likely be back below 2% in Q2 2024.  While some of this is favourable base effects, it does help reinforce an anchoring of long-term inflation expectations and can help start the easing cycles – we see this coming from the ECB and BOE most likely in June.  Some uncertainty will exist over the multi-year level of policy rates, as neither central banks wants to provide clear views on a neutral policy rate in contrast to the Fed.  However, up to 150bps of cumulative cuts in 2024 and 2025 looks reasonable for most players against the European macro backdrop. We can see more in 2026, given our European disinflation story – but the market will likely only take this view, as the easing cycle starts and inflation data undershoots central bank forecasts.   

3.       Fed caution.  The January FOMC minutes (here) show caution and a desire not to cut too quickly, but market thinking now appears more aligned to Fed officials than was evident in early January.  We have trimmed our forecast to 75bps cumulative Fed Funds cuts in 2024 now starting in Q3 as the U.S. economic slowdown is less likely now (here), but still look for 100bps of cuts in 2025 as the Fed seeks to avoid policy being too tight for too long.  A skew also exists in alternative Fed policy scenarios around our central view, with any noticeable downside growth or inflation surprises versus the Fed medians likely to produce more than an extra 25bps of easing.  Excluding the 2007-08 GFC, lots of examples exist where the Fed reacts quickly to any economic weakness (Figure 2).   

Figure 2: Previous Fed Rate Cut Cycle (%)   

Source: Continuum Economics

4.       Lagged Tightening Effects and Adverse Surprises.  We would also provide a reminder that most DM central bank tightening cycles have been aggressive and come after a 12-14yr period where borrowers had become addicted to ultra-low interest rates.  The lagged effects of the 2022-23 tightening are still coming through.  Banks are now starting to see non-performing loans pick-up, especially as the office based property sector continues to suffer the COVID triggered shift to hybrid working.  In the U.S. and Europe, this is not a systematic banking problem, but certain weak banks could be vulnerable and will have to be taken over or resolved.  Any mid-sized problems could cause a scare, just like SVB in 2023 that boost market easing expectations.