We have seen huge swings in Fed rate cut pricing this year as markets struggle to put incoming – and often conflicting – macro data in context. The U.S. economy’s unexpected recent resilience led markets to price out some rate cuts. But we do not think this is a typical business cycle. The unwind of pandemic-era supply shocks and a temporary immigration boost explain much of inflation’s cooling, in our view. That is why U.S. wage growth cooled from near 6% annually in early 2022 to around 3% now. See the chart. Yet last week’s labor data show wage growth is still strong, and current levels suggest core inflation could stay nearer to 3% versus the Fed’s 2% target. We see mega forces, structural shifts driving returns now and in the future, at play that could keep inflation sticky longer term – notably an aging population that would limit labor supply and future growth.
A still-thriving economy – even as the Fed has only just started cutting rates – has spurred markets to price out some cuts. Futures markets now show policy rates settling around 3.7% by the end of 2025, up from 2.8% in September, LSEG Datastream data shows. Yet markets are pricing in more Fed cuts than the central bank is likely to deliver, in our view.
Inflationary forces
Why? We see inflation staying higher than pre-pandemic levels. U.S. Q3 GDP data last week showed consumer spending is still driving overall economic growth. Average monthly job creation over the past three months now stands at 104,000 after last week’s jobs report – still a healthy pace and one likely to pick up given hiring stalled due to hurricane-related disruptions. As the U.S. election occurs, neither presidential candidate is focused on budget deficits that are likely to stay large no matter who wins. The prospect of higher tariffs or reduced legal immigration would also have inflation implications. Population aging and other mega forces are inflationary, too. Massive capital spending and reallocation from the artificial intelligence buildout may spur inflation, as could increasingly complex global supply chains due to geopolitical fragmentation.
Market pricing of ECB rate cuts is more in line with our view than in the U.S. The ECB tightened by more than the Fed on the way up – 450 basis points from January 2020 to the peak versus 375 for the Fed. ECB policy looks even tighter given Europe’s weaker consumer spending and limited fiscal support compared with the U.S. Tight policy gives the ECB more room than the Fed to cut rates to jump-start growth. That is why the ECB sped up the pace of easing in cutting rates a third time last month, making each policy meeting a live one. We see the ECB cutting to around 2%, consistent with market pricing. This drives our preference for European fixed income over the U.S., especially in credit. UK bond markets are eyeing the potential inflation impact of the tax and spending mix in the UK’s new budget. We see a tepid UK growth outlook driving the Bank of England to cut more than markets have priced in. That is why we recently went overweight UK gilts.
Our bottom line
This is not a typical business cycle. We see structural forces holding inflation higher long term, keeping the Fed from cutting as much as markets expect. ECB rate cut pricing is closer to our view, one reason we prefer euro area bonds.
Market backdrop
U.S. stocks slipped last week, with tech leading the way down after some mega cap tech companies failed to deliver on high expectations for earnings guidance. Tech’s troubles and weak U.S. payrolls for October overshadowed strong U.S. Q3 GDP growth fueled by resilient consumer spending. U.S. 10-year Treasury yields reached four-month highs near 4.40%. UK 10-year gilt yields hit 11-month highs after the new UK government budget boosted planned borrowing for investment.
Central bank policy decisions are in focus this week. Markets widely expect both the Fed and BOE to cut rates another 25 basis points Thursday and will be watching for clues on the pace of future easing. The UK growth outlook is weaker than in other developed markets, meaning the BOE may cut further than the Fed in coming years, we think. Markets have come closer to our ultimate U.S. rate pricing, yet we still see rates settling higher than markets expect.
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