Why US rates still need to be cut

Miller says the present low unemployment rate in the US, combined with strong GDP growth and inflation above the Federal Reserve’s 2 per cent target “are conditions not normally associated with rate cuts”.

But he says the markets need “reassurance” because during the period when rates in the US were very low, many companies were able to borrow cheaply, but those businesses will need to refinance that debt in the coming years. 

Miller says the market would be concerned about the prospects for those businesses if they have to borrow at much higher rates, and as a result the market will ascribe a much lower valuation to the equity of those businesses. 

It is with this in mind that Miller says at least one rate cut will happen this year in the US, and notes if it does not happen, "then the markets will be vulnerable". 

One rate cut this year, which is what markets are presently pricing in, would represent a significant reduction relative to the six rate cuts that were priced in last November, a scenario that led to a strong rally in bond and equity markets.

Miller says a feature of economies and markets in the coming years will be a divergence between the paths of the eurozone and the UK, with the relatively weak economic performance of those areas making it more intuitive to cut rates. 

A challenge faced by policymakers, and already reflected in the recent weak performance of sterling, is that the UK or eurozone cutting rates before the US does would cause the currencies of those countries to be weak relative to the dollar – something that is itself inflationary as it increases the cost of imported commodities such as oil and basic metals, as those are priced in dollars wherever in the world they are extracted.  

Despite that concern, he says he expects the eurozone will “need to cut rates over the summer”, with the Bank of England following shortly afterwards. 

Core inflation looks set to remain closer to 3 per cent.Rupert Thompson, Iboss

Stephen Blitz, chief US economist at GlobalData TS Lombard, says the strong US dollar also has negative consequences for that economy as it makes exports of industrial goods more expensive at a time when a central plank of President Joe Biden’s economic agenda is the 'reshoring' of industrial production.

If the goods are exported from the US, rather than from a cheaper manufacturing site abroad, then the cost base and selling price is in dollars, making it more expensive to export. 

Björn Jesch, global chief investment officer at DWS, expects the dollar to remain strong due to the higher yields offered by US government bonds attracting external capital, almost regardless of what happens with rates from here. 

On the potential for UK interest rates to fall, Rupert Thompson, chief economist at Iboss, says: “Here in the UK, BoE governor Andrew Bailey has professed confidence that inflation is coming under control in line with its forecasts, even though it did not fall as much in March as had been hoped.

"While the headline and core rates did slow to 3.2 per cent and 4.2 per cent respectively, domestically generated inflation pressures remained elevated with services inflation still running at 6.0 per cent. Wage growth also came in higher than expected in February, with average earnings excluding bonuses up 6.0 per cent on a year earlier.

"Yet at the same time, signs of a significant softening in the labour market are now emerging. Employment is falling and the unemployment rate rose to 4.2 per cent from 3.9 per cent. This weakening, along with the marked fall in inflation from last year’s highs, should ensure wage growth continues to moderate slowly.

"Still, while headline inflation remains on track to dip temporarily below the BoE’s 2 per cent target over the next couple of months, core inflation looks set to remain closer to 3 per cent.

"Most likely, the BoE will start cutting rates over the summer, if not as soon as June when the European Central Bank looks set to begin.” 

Market movements 

The area of the market where movements in rates and rate expectations would expect to be most acutely felt is in the bond market.

The asset class rallied strongly in the final quarter of 2023 as investors began to price in rate cuts, but that has revised more recently. 

Miller’s view is that bond prices will likely stay within a narrow range – that is, not be particularly volatile – because at present yields are not sufficiently high to be impacted starkly by an inflation shock, nor sufficiently low to be impacted by a growth shock.

He notes that recent geopolitical events did not precipitate investors rushing into bonds as a safe haven – the normal reaction to uncertainty – and he says this demonstrates that yields are not particularly high. 

Most likely, the BoE will start cutting rates over the summer, if not as soon as June when the European Central Bank looks set to begin.Rupert Thompson, Iboss

Thompson is slightly more optimistic about the prospect for bonds, noting that yields have moved sharply since the start of 2024, with the US 10-year government bond yield having risen by about 80 basis points since the start of the year, whereas he felt that equity valuations did not move to reflect the changed reality of revised interest rate expectations of recent months. 

He says: “This month, however, equities have suffered along with bonds. In part, this is simply because global equities were ripe for a correction, having seen no meaningful set-back during the 24 per cent run-up in prices since the end of October. But it is clearly also partly a response to the escalation of the conflict in the Middle East.

"That said, fears on this front had abated by the week-end following signs that Israel and Iran were stepping back from any further escalation. Indeed, oil prices ended the week down 5 per cent.

"The correction in equities, however, is also a result of expectations for a soft landing, which had been increasingly priced into markets, now starting to be replaced by talk of ‘no landing’.

"Namely, the idea that while there is no imminent recession in prospect, inflation will prove somewhat sticky without one and not allow interest rates to fall half as far or fast as had been hoped.”

Since Thompson made those comments, equity markets have rallied as the geopolitical threats appear to have modified, showing the extent to which macro events continue to drive markets.

David Thorpe is investment editor at FT Adviser