The first cut is the deepest?

• Asian ex Japan equities rallied +1.2% in sterling terms
• Brent Crude rallied 4% in US dollar terms

• Equities were broadly weaker in sterling terms. Japan equities fell -1.3% in sterling terms and European equities slid -1.1% in sterling terms
• Bonds also sold off broadly, with gilts down -1.1%

On Wednesday, the US Federal Reserve (Fed) started the much anticipated interest rate cutting cycle with a bumper 0.5 percentage point (50bps) cut, lowering the federal funds rate to 4.75%-5%. This move by the Fed is the first rate cut in more than four years. The jumbo 50bps cut – until recently unexpected – was not a complete surprise when it came to the vote by the rate setting Federal Open Markets Committee (FOMC), and sent a clear message to market participants that the Fed are willing to act decisively.

The Fed guided to a further 50bps cuts this year, ie two 25bps reductions at the final two FOMC meetings in 2024. Additionally, the Fed adjusted their forecast unemployment rate, now anticipating it to peak at 4.4%; up from 4.2% forecast previously but still not a particularly high level by historical standards. With regards to inflation, the Fed still anticipates that it will take another two years for core PCE inflation (the Fed’s preferred measure) to get back to the 2% target level, but the bumper rate cut suggests the Fed are confident that inflation is well under control in the absence of a significant external shock.

Speaking in the wake of the decision, Fed Chair Jerome Powell explained the decision was motivated by a desire to ensure that high interest rates did not do unnecessary damage to the economy, although the accompanying statement suggested that Fed officials were not overly worried about the potential for an imminent recession. Gross Domestic Product (GDP) was described as ‘solid’. Overall, despite the bigger initial cut, unless Fed officials become more concerned about the downside risks to the labour market, it looks like we will see a more measured pace of 25bps rate cuts from now on.

As well as the potential risk of executing a large rate cut against a relatively resilient US economic backdrop, a further concern was that of becoming embroiled in political debate, with the US presidential election so close. Indeed, Republican candidate Donald Trump was quick to comment, stating that the cut was either made for ‘political’ reasons to help Kamala Harris, his opponent in the presidential election race, or because the economy is in ‘very bad’ shape. Chair Powell reiterated that the Fed decisions would be entirely economic data dependent.

After a rate cut from the Bank’s Monetary Policy committee (MPC) in August, the BoE decided to hold interest rates at 5% last week. The member’s vote was 8-1, with only one member voting to cut rates by 0.25%. ‘In the absence of material developments’, the committee decided that a gradual approach to removing policy restraint remains appropriate. Following the meeting, the BoE’s governor Andrew Bailey explained the reasons why, stating that it is ‘vital that inflation stays low’, and noting that the MPC needs to be careful not to cut rates too fast or by too much. Reiterating the view that policy will need to remain restrictive until the risks of inflation not returning sustainably to the 2% target have completely dissipated.

However, the pause from the MPC is not expected to last long, financial markets are still expecting one or two further rate cuts this year, with an expected rate of 3.75% by June 2025. There is no meeting in October, so market participants must await the November MPC meeting for further comment and developments.

Following this week’s decisions by the Bank of England and the US Federal Reserve, sterling strengthened against the US dollar, with a pound buying USD1.33, the highest level in more than two years.

August’s inflation was released the day before the MPC meeting, with the print giving committee members no reason to rush into further interest rate cuts. Headline inflation was unchanged at 2.2% in August, although services inflation has now risen by 5.6% in the year to August, up from 5.2% in July. Airline prices rose particularly strongly in August, up by more than 22% - while this was partly down to cyclical factors and boosted by summer holiday demand – it was the second largest month-on-month rise in airfares since 2001. With services and core goods inflation rising, the core inflation print has now reached 3.6%, in line with BoE expectations.

The official house price index fell for the first time since December 2023, likely due to the relative lack of demand during the summer holiday months. Aggregate data suggests UK house prices have now gained 2.9% so far this year, with the average month-to-month rise at 0.4%, and the anticipated interest rate cuts likely supporting demand.

Elsewhere, retail sales data showed continued improvement, as year-on-year retail sales volumes grew by 2.5% in August, up from 1.5% in July and well above consensus expectations. Consumers have likely been cheered by real income growth, as inflation slows and borrowing costs come down.

Looking ahead, there is a risk that the UK consumers’ confidence might take a hit following the Autumn Budget on 30 October, with a fear of notable tax hikes at the forefront of observers’ minds. Weaker sentiment might persist into October ahead of the Budget, and this could seep into growth forecasts, with the new government pre-emptively warning of ‘tough choices’ and ‘painful decisions’. However, confidence is expected to rebound towards the end of the year as economic fundamentals remain resilient and show signs of improvement.

 

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