Back in June when the Bank of England unexpectedly raised rates by 50bps to 5% on the back of much more hawkish commentary from the likes of the Federal Reserve, as well as the ECB, market pricing for UK rates rose to 6.25% in a move that looked clearly overpriced.
UK 2-year gilt yields spiked up to 5.56% and their highest levels since 2008 as markets grew concerned that further aggressive moves on rates would be needed to contain the inflation genie, which in the UK was proving to be much stickier than expected.
At the time I suggested that these concerns were overstated given the direction of travel on headline inflation in the US, as well as in Europe, which was already slowing sharply, not to mention what we were also seeing in China where we were seeing clear evidence of deflation.
Other warning signs of sharply slowing inflation were evident in the PPI numbers which in Europe have been negative for over a year now, and which in the UK have been negative, or close to negative since July.
Yesterday US CPI for October also confirmed that inflation was heading lower, slowing from 3.7% to 3.2%, while core prices slipped from 4.2% to 4.1% in a sign that price pressures were continuing to slow.
More importantly super core inflation which the Fed monitors closely also slowed as well, and with the risk of a US government shutdown this weekend postponed until January next year, the economic risks to the US economy appear to have diminished further.
Bond markets are already reflecting this narrative even as central bankers continue to push the higher for longer narrative, with US 10-year yields falling to their lowest levels since September, below 4.5%, having risen as high as 5.01% in October.
Today UK headline inflation showed another sharp slowdown, dropping from 6.7% in September to 4.6% in October as the effects of the energy price cap fell out of the headline number for the second time this year.
Having seen the cap come down in April, headline inflation slowed to 8.7% from 10.1% in March, and knowing that further reductions were coming in June and October it wasn’t unrealistic to assume similar sharp slowdowns in these months as well, which is precisely what has happened with October CPI slowing to 4.6% and core CPI slowing to 5.7%.
Of course, we’ve heard a lot today from the UK Treasury, as well as the government that they have succeeded in their goal to get CPI below 5% by the end of the year, which is hilarious given that what we’ve seen today has happened despite them, and not because of them. Let’s not forget this is the government which raised tax rates and made people worse off.
The reality is this was a goal that was always easier to achieve than not, given what we have been seeing in headline PPI numbers these past few months, and the fact we knew the energy price cap was keeping inflation higher than it should have been.
The actual reality is were it not for the design of the energy price cap, headline inflation would have fallen much quicker than it has, merely confirming the idea that there is no political intervention that can’t make a big problem even worse, and which in turn helped to create the very stickiness we are seeing in wages growth which is making services inflation stickier than it might have been.
This has meant that UK services inflation has taken longer to come down than it should have, although we have seen a modest slowdown to 6.6% from 6.9% in September.
The effect of the energy price cap is evident in where we’ve seen the biggest slowdown in October inflation, with household and services inflation declining -1.9% month on month, compared to an 8.7% increase in October 2022. Gas costs fell 31% in the year to October 2023, while electricity costs fell 15.6%, which is the lowest annual rate since January 1989.
That said gas and electricity prices are still well above the levels they were 2 years ago, with gas prices still higher by 60%, but nonetheless what the last 24 hours have told us is that its increasingly likely that central banks are done when it comes to further rate hikes, and that pricing is now shifting to who is likely to cut rates first.
On that count the jury remains out, however given the recent gains in the US dollar over the last few months, the repricing of rate risks suggests that the US dollar might still have the biggest downside risk even if the Fed is the last to start cutting.
On that score it looks to be between the ECB and the Bank of England when it comes to which will cut rates first with markets pricing 78bps from the Bank of England by June next year. At this point this seems a little excessive in the same way markets were pricing a 6.25% base rate back in June.
That said the thinking has shifted, and rather than higher for longer further weakness in the economic data will only reinforce the idea that rates have peaked and that cuts are coming, with the debate now on extent and timing. This is no better reflected than in the UK 2-year gilt yield which is now 100bps below its June peaks having fallen as low as 4.54% earlier today.
On the score of who is likely to be first out of the traps in rate cuts it’s more than likely to be the ECB, perhaps as soon as the end of Q1 next year, with the Bank of England soon after, which will be good news for households, as well as governments when it comes to debt costs.
Despite today’s undershoot on UK inflation the pound has managed to hold onto most of its gains against the US dollar of the last 24 hours having hit 2-month highs earlier today, above 1.2500 and closing above its 200-day SMA for the first time since 13th September yesterday.
The euro has also rallied strongly, similarly closing above its 200-day SMA, in a move that could signal further gains, while equity markets also rallied strongly.
The strongest moves came in the Nasdaq 100 and S&P500 which posted their biggest one-day gains since April, with the Nasdaq 100 coming to within touching distance of its July peaks at 15,900. We need to see a concerted push through here to signal a return to the 2021 peaks.
The S&P500 similarly broke out of its downtrend from its July peaks, retesting its September peaks, with a break of 4,520 potentially opening the prospect of a return to those July highs at 4,590.
While US markets have rallied strongly, the reaction in Europe has been much more tepid which suggests an element of caution when it comes to valuations for European stocks.
The DAX has managed to recover above its 200-day SMA and above its October highs, while the FTSE100 reaction has been slightly more measured compared to the FTSE250 which has seen strong gains this past two days, pushing up to 2-month highs in early trade today.
In summary today’s inflation numbers are good news for consumers across the board, especially given that headline CPI has fallen below the base rate for the first time since 2016, however the Bank of England will still be concerned about services inflation, as well as wage inflation, which is still above 7%.
While markets are cheering the end of inflation it is clear that central bankers will be reluctant to do so less it return in 2024.
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