- Financial conditions look decidedly mixed
- Are markets still getting ahead of themselves when it comes to rate cuts?
March’s central bank meetings have come and gone and base rates are still on hold, as they have been in the UK and US since last summer.
But take a look at mortgage rates, and the picture is very different. In the UK, they have fluctuated significantly since the Bank of England last hiked rates in August. The two-year swap rate, which plays a key role in the pricing of fixed-rate mortgages, currently stands at 4.6 per cent – up from 4.3 per cent in January, but far lower than the August high of 6 per cent. The base rate hasn’t gone anywhere, but borrowing costs certainly have.
What financial conditions are telling us
This highlights a key tension for rate-setters: they can adjust the base rate, but have to rely on financial markets to pass this through to households and firms. Laith Khalaf, head of investment analysis at AJ Bell, says that “in anticipating interest rate cuts, markets have already done some of the heavy lifting in providing relief to businesses and households”.
In March, the BoE’s Financial Policy Committee warned that financial markets are putting “less weight” on risks that could cause rates to stay elevated, meaning that asset prices have soared to levels that look “high relative to historical norms”. Does all this mean that investors have got ahead of themselves?
The gulf between what markets and policymakers expect is smaller than it was at the start of the year. In January, markets placed their bets on a first US rate cut in March (which proved premature) and anticipated around 1.5 percentage points of easing over the year ahead. According to the CME FedWatch tool, traders now think there's a 60 per cent chance of a first rate cut in June, and see a more modest 0.75 percentage points of cuts in 2024 – roughly in line with the Fed’s own projections.
In the minutes of the latest BoE rate-setting meeting, policymakers noted that investors were less optimistic about rate cuts than at the start of the year, but warned about “mixed signals on the direction of the overall change in financial conditions”. Rate cut hopes might have dimmed since January, but equity prices have risen, mortgage rates have retreated and corporate bond spreads have narrowed over the same period.
US rate-setters seem unconcerned. When asked at the end of March whether easing financial conditions was compatible with a return to the US inflation target, Fed chair Jerome Powell said that “ultimately, we do think that financial conditions are weighing on economic activity”.
Not everyone agrees with this interpretation. Sonal Desai, fixed income CIO at Franklin Templeton fixed income, found the comments “rather a stretch”, given that “the sustained rally in asset prices has been moving with full force against the Fed’s monetary tightening”. The Chicago Fed National Financial Conditions Index shows that conditions are looser than average and have eased since rates were last hiked over the summer.
Rate cuts are still on track
But financial conditions can be hard to pin down. At their core, they measure how easy it is for businesses and individuals to access finance – yet different indices capture subtly different things. After the last meeting, Powell argued that given the multitude of different indicators, you can arrive at a different answer depending on which one you use.
Powell also pointed out that the US saw significant progress on inflation last year, “despite financial conditions sometimes being tighter, sometimes looser”. The relationship between interest rates, inflation and these conditions isn’t straightforward. Crucially, Fed rate-setters don’t seem too worried about buoyant US stock markets – and certainly not worried enough to delay rate cuts.
We could even find that investors have set their expectations for easing this year too low, especially when it comes to the UK. AJ Bell’s Khalaf thinks since the BoE has been so slow to make “dovish noises”, it could shock markets by loosening faster than expected this year. But we don’t need to wait for interest rates to be cut to feel the impact. If the past six months have taught us anything, it’s that mortgage rates and stock markets will move on the expectation of interest rate changes alone.
