The major global economies seem poised for a period of low interest rates. This could be an opportunity for those seeking to borrow money from one country and invest it in another; but could imply greater risk for those seeking to invest (or hold bank accounts) in the low-interest-rate countries. Any talk of lower interest rates or a continuation of lower interest rates has helped to pile the pressure on Sterling which is hovering around a 4-month low against a broad basket of currencies.
So interest rates, have become a talking point again because, as global trade tensions ratchet higher and show little sign of being resolved, central banks have continued to shift towards a more dovish stance. We will start with US interest rates.
A striking dynamic in financial markets at the moment is the divergence between market expectations for the future path of Fed Funds, and the FOMC’s own ‘dot plot’ projections (Fig. 1). The market has moved to price in ~100bps of cuts in Fed Funds by the end of 2020. This is at odds with the FOMC’s official projections, although there has been a softer tone to recent Fed comments. The US Federal Reserve Chairman Jerome Powell hinted at the potential for a rate cut (which has been priced in by financial markets for some time), saying that the central bank would “act as appropriate to sustain the expansion”.
There has been some spillover to expectations for UK interest rates where the market-implied path is now notably lower than at the time of the May Inflation Report (IR) a month ago, and doesn’t price in a full 25bp hike until after the five-year horizon. By historical standards, the current Bank Rate hiking cycle (if the two 25bp hikes so far is enough to qualify as a cycle) has been slower and shallower than previous cycles.
The market-implied path of expectations therefore certainly doesn’t point towards this cycle speeding up.
The exact timing of the next hike will, as usual, depend on the MPC’s analysis of the incoming data, and judgments about the outlook both domestically and globally where trade tensions are an ongoing concern and partly explain the drop in market interest rates. For now though, it appears that the Committee feels it is able to wait for the current period of domestic political uncertainty to abate.
This fits with analysts’ forecast that the next Bank Rate hike won’t come until Q1 2020. In the meantime instead this provides the opportunity to review some of the broader structural dynamics that might also inform the development of the current cycle. Firstly, the Bank’s estimate of the neutral rate is lower than it used to be. That means one 25bp move is a greater proportion on the total journey to the MPC’s destination than it used to be.
This supports the view that if the MPC do go onto extend this cycle, it will continue to be at a pace that is much slower than previous cycles.
Secondly, the Bank has presented evidence of a dampening in the ‘pass-through’ of interest rate changes to the economy. In contrast to the implication of a lower neutral rate, if the Bank now thinks it gets less bang-for-its-buck, it implies more tightening sooner to have the same overall effect. A lower neutral rate is an argument for the MPC to consider a proportionate reduction in the magnitude of individual step changes in Bank Rate through the cycle. However, evidence of less pass-through is an argument against refining Bank Rate changes to steps of less than 25bps. As such, it seems likely that if the economy evolves as the MPC expect, the resumption of rate hikes after the current period of political uncertainty will continue in steps of 25bps, and that the pace of tightening will be very slow by historical standards.
The ECB, meanwhile, pushed out its guidance for the earliest first rate rise to mid-2020, while the possibility of rate cuts and restarting QE was raised during its policy discussions.
The Reserve Bank of Australia cut interest rates to a record low of 1.25%, the first reduction in nearly three years.
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