Rates will be cut – But how much and how soon?

The strong decline in US and European bond yields continued in the second half of December, as market expectations firmed for rapid and large interest rate cuts from central banks in 2024. This followed from dovish signals from the Fed earlier in December and signs that inflation is under control, and despite what seems to be attempts by some central bankers to moderate the expectations. In the first week of the new year, however, markets have moved a bit in the opposite direction, perhaps reflecting that the decline in bond yields and the accompanying increase in equity prices by themselves might stimulate economists so much that inflation rises. Our view continues to be that markets are pricing more rate cuts than are likely in 2024 in the US and the euro area, as we expect central banks to be cautious. Risks of inflation re-igniting are not gone, given tight labour markets and areas of high wage growth, for example. Our forecast is 100bp of rate cuts in the US this year beginning in March, and 75bp from the ECB beginning in June.

The US added 216,000 jobs in December and hourly earnings grew 0.4%, both above expectations. Job growth in November was revised down, but all in all, most data points towards a still-strong US labour market. Euro area inflation was 2.9% y/y in December as expected, up from 2.4% in November. The increase is mostly related to a lower comparison point for energy prices. The underlying momentum in core prices (measured as last three months compared to previous three months) is still declining and corresponds to 1.4% annual core inflation in the latest data, using ECB's seasonal adjustments. However, service price momentum is at 2.3%, which is likely still a worry for the ECB. PMI data from the US, Europe and Asia mostly suggest that the global manufacturing recession is coming to an end, and some leading indicators even suggest that we might be in for a modest manufacturing upswing.

One inflation risk factor continues to be conflict in the Middle East, where Houthi forces from Yemen have been attacking ships in the Red Sea. This has caused many shipping companies to send their ships around the Cape of Good Hope instead of through the Suez Canal, leading to significant increases in freight rates and shipping times. However, rates remain far below the heights seen in 2022, and we continue to see supply disruptions as much less of an inflation threat now than when excessive global demand strained supply chains to their outmost. Oil markets remain calm despite the risk that hostilities can escalate further, but of course, this could change.

The most important data release during the coming week will likely be the US CPI for December. Monthly core inflation was 0.3% in November and that is also our expectation for this release, still a bit to the high side for the Fed. Euro area unemployment is also interesting given the ECB's high degree of focus on the tight labour market, but indicators do not suggest that it increased in November from 6.5% level the month before. China will likely release another negative inflation print but with core inflation still positive, albeit low. We expect 2024 to be the year when Japan finally exits negative interest rates and that depends on price and wage growth, both of which we get data for this week. However, we will likely have to wait for the spring negotiations before seeing wages move much higher.

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