US and UK rate decisions: no surprises – but changed expectations

Two central bank meetings last week saw two entirely expected decisions. But the context of those decisions will have an impact into 2025.

The Federal Reserve

On 18 December, the Federal Reserve (Fed) cut interest rates by 25bps taking the target rate to 4.25%-4.50%. This was fully priced in ahead of time by the market so to do anything other than cut interest rates would have been a major surprise to the markets. The bigger question was….did the committee really want to make this cut? The simple answer was they did it…but reluctantly. Leading up to the committee meeting, the economic data had continued to be reasonably robust. There were still signs of a softening labour market and a slowing of services activity, however prices paid, wages and inflation data continued to remain sticky and more worryingly for the Fed, consumer inflation expectations are rising.

The commentary from chairman Powell suggested that the Fed now need to move towards a much slower pace of easing. After the committee meeting in November the market was expecting four interest rate cuts in 2025, as at that time the Fed were more concerned about the unemployment side of the equation. However, the summary of economic projections highlighted an upward revision to core inflation and a downward revision to unemployment which swung the needle back towards tackling inflation. Powell referred to this specific point, namely that inflation was not where they wanted it to be at this juncture and as a result the ‘dot plot’ (which shows committee members’ forward rate guidance) suggested that there would now only be two interest rate cuts in 2025. The dots also highlighted that some members of the committee felt it appropriate to increase their view of the longer term neutral interest rate in the US. The market reaction saw yields higher and curves steeper on the assumption that the combination of ‘higher for longer’ interest rates and a heavy supply picture should equate to increased term premia in yield curves.

some members of the committee felt it appropriate to increase their view of the longer term neutral interest rate

Who knows what will happen in 2025. The biggest issue is uncertainty in the prospects of policy changes by the Trump administration after inauguration in January 2025. At the November meeting Powell had stated that the committee does not set policy on speculation. However, at this meeting he inferred that until we have more clarity, we may have to sit on our hands a bit longer. So it is clear now that Trump policy is firmly in play…first up will be his executive orders (we believe most likely tariffs) and this will set the early tone for markets and the Fed in 2025….hold onto your hat it could be a wild ride!

Bank of England

At Thursday’s Bank of England (BoE) meeting, the committee voted to keep interest rates at 4.75%, by six votes to three. Whilst the decision to hold rates was fully expected by the market, the vote split was more dovish than anticipated with the market forecasting that only one member of the committee would call for an immediate reduction in rates. Whilst December’s meeting was not a monetary policy report month, the BoE downgraded its forecasts for growth, such that it is now expecting the UK economy to deliver ‘zero growth’ in the final three months of 2024. But BoE’s mandate when setting monetary policy, is to deliver Consumer Price Inflation (CPI) of 2.0%, not growth. The minutes of the meeting focused on the impact of the Chancellors decision to raise both the national living wage and the rate of national insurance paid by employers and its potential impact on inflation uptick. As we head into 2025, Inflation looks set to remain elevated for much of the next 12 months; market expectations are for CPI to remain well above target until the middle of 2026. What is evident is that the BoE has a real challenge ahead: how to balance a faltering economy with zero growth alongside sticky and persistent inflation.

But none of this is new news for the market. Ever since the Labour budget was announced, and the Office for Budget Responsibility provided an independent assessment of the Chancellor’s flagship policies, markets have been nervous about the impacts of those policies on both growth and inflation. The toxic mix of persistent and above-target inflation, with a weak and faltering economic growth story into and post the budget, has been weighing on investor confidence for some time. Gilt yields have been rising in sympathy with global moves, but it is the underperformance of the UK gilt market versus its peers that is most stark. The spread between 10-year maturity UK government bonds and German bunds is as wide as it was in September 2022 in the aftermath of the ill-fated Lizz Truss mini budget. But this time it feels different. That was a market shock, which was exacerbated by leverage within the system, particularly pension funds. This time round it has been a slow bleed. As growth trundles along, survey data weakens, and the probability of a recession increases by the week, the already high debt burden is weighing on investor sentiment. Markets are once again questioning the UK's debt sustainability.

As markets re-open in the New Year, and bond supply picks up, the government will be desperate for a change in fortune. In our view, the UK bond market feels mispriced given the current state of the economy. Patience may be required during the first half of the next year, but we expected the BoE to deliver more cuts during 2025 than are being priced by the market. But with growth faltering, and supply remaining high, investors could remain nervous of longer maturity bonds. One wonders, without a change in fortunes, who will be the buyer of all these gilts?

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.