A tale of three central banks, and why stocks are in recovery mode

One of the biggest developments as we move to the end of this year is the divergent narratives of the main central banks. The Fed is cutting rates although the economic outlook is unclear, the ECB remains noncommittal on the future outlook for rates and upgraded its forecast for inflation next year, the BOE is reluctantly cutting interest rates and a sizeable number of policy committee members remain concerned about sticky wage growth, while the market is almost certain that the Bank of Japan will hike rates tomorrow.

FX volatility to reflect central bank divergence

This should not be unusual, after all, they are separate economies with different fiscal and growth outlooks, however, it does raise the possibility for greater volatility in the FX market and stock market divergence next year. The USD has been the weakest currency in the G10 FX space so far this year. The JPY is the second weakest, however, If the BOJ continues its normalization of monetary policy, then the JPY could extend gains beyond the 1.2% increase vs. the USD that it has recorded for this year.

Can the euro rally weigh on growth?

Likewise, the 13% annual increase in the euro vs. the USD has not got in the way of the ECB’s rosy economic forecast so far, but can growth in the currency bloc really pick up if the euro remains this strong, especially when the threat of US tariffs remain ever present? Another bumper year for the euro could spell economic pain for the currency bloc, especially since the ECB has stated that the bar is high for further rate cuts.

Resurgent pound as hawks won’t throw in the towel just yet

The pound is in the middle of the G10 FX pack for 2025 and is higher by 7% vs. the USD. The pound has ticked along this year, without any major bouts of volatility even though growth has flatlined since June and the Budget caused a large dent in consumer and business confidence.

The pound has surged this afternoon, even though the BOE  cut interest rates as expected. GBP/USD has risen nearly 100 pips and is above $1.3430. There are two reasons for this. The first was the larger than expected drop in US inflation, which we will speak about in more detail below, the second is the nature of today’s rate cut. The cut was widely expected; however, the focus was on what today’s meeting would mean for the future of UK interest rates. The vote split was tight, 5-4 in favour of a cut, ahead of this meeting, there had been some expectations that the split could be 6-3, which would suggest that the doves have control at the Bank. That was not to be, and the hawks remain an important faction at the BOE. Their biggest roadblock to further rate cuts is sticky wage growth, and this is not falling quickly enough for some. For example, the Recruitment & Employment Federation and KPMG’s private sector employment survey found that wage growth picked up this month.

Due to the implacableness of the BOE’s hawks, today’s BOE rate cut did not move the dial for UK rate expectations, with just over one cut still expected for next year. UK Gilt yields are rising at the short end of the curve, as investors price out the prospect of a series of rate cuts from the BOE in the coming months. This is boosting sterling.

Questions around shelter component of CPI

Across the pond, the sharp fall in US inflation, from 3.1% to 2.7% was unexpected. The core rate also registered a large decline. There are questions around this data, including the timing of collection, which coincided with the end of the government shutdown. Issues surround the shelter component, which rose by a mere 0.1% last month, the average rate for shelter costs for the first 9 months of the year was nearly 0.6%. Although there is some skepticism in this data, US Treasuries are outperforming and US yields are declining. Added to this, the dollar index is now below its 100-day sma and is testing the recent low at 98.00.

November inflation report supports Fed rate cutting cycle

Stocks are also rising on this cooler than expected CPI data. Even if there are some discrepancies in this data, the November CPI reinforces the downtrend for US inflation, which is reassuring for the Fed and may allow it to embark on a protracted rate cutting cycle in 2026. This would differ from other major central banks’ rate paths, which is why the dollar is selling off on a broad basis today.

Santa rally still a possibility

This drop in prices is also positive for stocks and paints a Goldilocks picture of the US economy: not too hot, and not too cold. US stocks have rebounded sharply on Thursday, and the Nasdaq is higher by 1.3%. US growth stocks like tech tend to do well when rates are falling. Before this, the prospect of a Santa rally was fading, and US indices are negative month to date. However, Micron’s strong results have rejuvenated the AI trade, and the CPI report is opening the door to a stock market rally into year end. Santa may have come late to financial markets this year, but they have not been forgotten.