Executive briefing: Market pricing for rate cuts seems excessive

• Rate markets have gone through a massive re-pricing and markets now anticipate 5-6 rate cuts by the Fed by year-end 2024 and even more by the ECB. We acknowledge that inflation has fallen faster than initially expected but we also think that market pricing has gone too far.
• Lower interest rate expectations led to solid performance for bonds, equities, credit markets and currencies such as the SEK and NOK in December.
• Labour market strength continues to uphold wage pressures, which continues to feed into service inflation particularly, and we still think that the path to central banks 2% inflation targets could turn out to be a bumpy one.
• Economic data in the Nordic countries is very mixed, but Swedish inflation has stated to surprise significantly on the downside.

As we enter 2024, focus is on when, how much and especially why central banks lower rates. Since our last update, interest rate markets have gone through a substantial repricing and markets now expect the Fed to cut rates to below 4% by end of 2024. Similarly, the ECB is expected to cut rates to below 2.5% from the current level of 4%. We acknowledge that inflation has fallen faster than initially expected but we also think market pricing has gone too far. We still think particularly core inflation could prove sticky as labour markets remain tight globally. Hence, we expect that the major central banks will rather adjust rates gradually lower to maintain a sufficiently restrictive real monetary policy stance, instead of opting for a full-on easing mode that the markets seem to suggest.

The euro area economy has lost steam much faster than the US economy, but overall, we are still set for a soft landing. Both manufacturing and service sector activity are now in recession territory in the euro area although December PMIs did not show further weakness. The US economy has been much more resilient thus far, but lower savings, cooling labour market and delayed pass-through of monetary policy will eventually hit consumption, in our view. On the other hand, in both regions, this could be a year of changing fortunes for households and businesses; households will feel relief as their real incomes recover and interest rates decline, while corporates still face rising labour costs that they most likely struggle to pass on to prices due to weakening pricing power.

Inflation could still prove stickier than expected, forcing central banks to keep rates higher for much longer than markets currently expect. Importantly, the recent rally in bond and equity markets implies looser financial conditions, which in itself supports growth and poses an upside risk to inflation. On the other hand, inflation could fall back faster than expected if the economy performs worse than expected. These risks are more pronounced in euro area compared to the US. In the US, fiscal policy is expected to remain supportive for growth which poses an upside risk to inflation, while EA countries will be required to tighten belt (see Flash: New EU Fiscal rules – A realistic compromise, 21 December).

Download the Full Report!