Rate rises are over – but markets will still be jittery

Interest rate changes move markets – after the past two years, investors hardly need reminding of this fact. Rising rates have seen bond yields move back up to levels that, in the words of Frederique Carrier, head of investment strategy for RBC Wealth Management, “make bonds a fully usable and attractive adjunct to stocks in a balanced portfolio”. At the same time, higher rates have also forced the stock market to “adjust to the new competition from bonds for investment dollars”.

Clearly, interest rates in the US, UK and eurozone have risen dramatically since the end of 2021. But after months of hikes, big rises gave way to smaller rises, before rates eventually plateaued. The big three central banks have now held rates constant since last summer.

As inflation cools, attention is turning to when those rates will be cut. Economists generally expect the Federal Reserve to cut sometime in the spring, while the Bank of England (BoE) is expected to follow later in the summer. But for the next couple of months at least, central banks will stand pat. But paradoxically, their impact on markets could prove greater than ever.

Interest rate announcements might be the best publicised piece of central banking kit – but they are not the only ones. Rate-setters use an array of channels to communicate their future policy plans, including press conferences, meeting minutes, speeches, forecasts, and interviews with the press. Crucially, these all can – and do – move markets. 

Verbal cues 

December last year proved a case in point. The BoE may have maintained interest rates at 5.25 per cent, but monetary policy was still huge news. Markets were first surprised when Huw Pill, the BoE’s chief economist, implied during a virtual Q&A session that rate cuts could come in summer 2024. This was rapidly contradicted by BoE governor Andrew Bailey, who told a banking conference that it was “far, far too early” to start talking about a change of tack. 

Markets rallied again later in December in spite of the Fed also electing to hold interest rates constant. In a press conference after its rate-setting meeting, Fed chair Jerome Powell said: “declaring victory would be premature… but of course the question is 'when will it become appropriate to begin dialling back?". These unambiguously dovish comments were accompanied by more optimistic ‘dot plots’ – projections indicating that rate-setters expected more rate cuts in 2024 than previously implied. 

Traders adjusted their own expectations accordingly, as the chart shows. According to the CME FedWatch tool, markets now see a 40 per cent chance that rates will be cut in March (after recentdisappointing inflation data), but a total of five to six cuts this year is still viewed as the most probable outcome.

Forecasts are not just for wonks 

These dot plots mark the Fed out. Though the ECB and BoE both issue projections for other economic variables (think growth, inflation and unemployment), they do not disclose the policymakers’ expectations for the future path of base rates. Research by ECB economists found that since 2020, there has only been a weak relationship between the tone of the Fed chair’s post-meeting press conferences and the market response. Instead, markets have come to rely on dot plots and forecasts when forming a view of the Fed’s next steps. 

In the UK, things are slightly different. Research from Vanguard chief economist Jumana Saleheen and colleagues found that, in the absence of dot plots, speeches by rate-setters carry more clout. Their findings implied that these had more impact on medium term gilt yields than either interest rate announcements or BoE Monetary Policy Committee press conferences. But this creates its own challenges. The researchers warned that “complex and ambiguous communication leads to greater asset price volatility than simple and clear communication”, adding that “central banks that want to avoid generating volatility in financial markets should keep it simple”. 

Ex-Fed chair Ben Bernanke is currently leading a review into the BoE’s forecasting practices, and there is speculation that the BoE could soon issue something similar to the Fed’s dot plots. Better forecasts could certainly make the BoE’s life easier – but only if the public believes in them. 

Plausibility 

As December showed, the mere mention of rate cuts can be enough to adjust expectations and buoy markets. When the public believes central bank messaging, communication can impact the economy in advance of the promised future policy change, ultimately leaving rate-setters with less work to do. To central banks, this credibility is a huge asset. 

Economists at the Federal Reserve Bank of Dallas created a ranking of central bank credibility for the period between 1990 and 2022. On the whole, the US was found to have the most credible central bank, followed by the UK. Japan lagged behind with a notably worse credibility estimate than other countries. This did vary over time. All central banks had higher credibility scores during the great moderation (1990-2007), and lower scores during the period of low inflation and low rates that followed the financial crisis.

Crucially, none of the central banks had ‘perfect credibility’, and, even more importantly, this made their recent battles against inflation significantly harder. Using a counterfactual, the Dallas Fed economists claimed that inflation would have started to decline fast – and sooner– in 2022 had central bank messaging been fully credible.

In this alternative scenario of a ‘perfectly credible’ BoE, UK inflation could have dipped to 4 per cent by the end of 2022. In reality, it sat closer to 8 per cent. In the US, the situation was similar: inflation could have ended the year close to 2 per cent if Fed comments had the credibility to influence economic behaviours to the maximum degree. Instead, it hovered nearer to 4 per cent. 

Have markets gone too far?

Traders are now pricing in relatively rapid cuts from the big three central banks over the course of the year. But what if these don’t materialise? Latest UK inflation figures surprised markets, following on from a similar outcome in the US and Europe. As the rate of UK consumer price index (CPI) inflation accelerated from 3.9 to 4 per cent, the case for early rate cuts suddenly looked too optimistic – and markets rapidly recalibrated. The two-year gilt yield rose by more than 20 basis points to 4.4 per cent. Following the release, the market-implied probability of the first interest rate cut coming in May fell to 55 per cent, from more than 80 per cent immediately beforehand.  

Last week, Bank of America (BoA) analysts said that they were “puzzled by the aggressive market pricing of rate cuts this year” given signs of economic resilience and uncomfortably sticky inflation. They argued that it was “worth considering” the consequences of central banks holding interest rates constant for the rest of 2024 – even if only as a contrarian exercise. As the table below shows, the dollar and the euro could perform well in this scenario, the pound could struggle, while the yen could do particularly badly. 

Given the (generally) downwards trajectory of inflation, this might look far-fetched. But expectations for rate cuts are still so high that BoA analysts think that “we may see a similar market reaction if rate cuts come later or slower than market pricing”. They see particular scope for market turmoil in the first half of the year if cuts are slow to materialise, although they note that this backdrop could support the dollar.

After two years of a hiking cycle, we now find ourselves in a very different position. Markets are pricing in a significant amount of rate cuts for 2024, but central bankers are expected to sit on their hands for the next few months at least. This doesn’t mean that rate-setters will be out of the headlines: speeches, forecasts and interviews will be pored over for an indication of how far rates could fall. It all serves to emphasise that central banks have a power to influence markets – not to mention the economy – separate from their interest rate decisions. Rates might not move until the middle of the year, but markets certainly will.