Officials from the US and European central banks "poured cold water", and the market "disarmed" to reduce the expectation of interest rate cuts within the year

Just as the market is carnivaling for interest rate cut expectations, this week, officials of the Federal Reserve, the European Central Bank, and the Bank of England have poured cold water on the market's bets on aggressive interest rate cuts. A series of remarks and data corroborate that the market finally had to "disarm and surrender", and lowered its expectations for the size of interest rate cuts by major central banks around the world this year and the timing of the first interest rate cut.

Why "pour cold water"

This week, the world's major central bankers expressed concern and caution about interest rate cuts from multiple dimensions such as employment, inflation and the resilience of the economic outlook. This is not unrelated to the experience of some major central banks misjudging inflation before the current round of aggressive interest rate hike cycle. Previously, many of the world's major central bankers had expected inflation to be transitory, and then inflation was stickier than expected and soared higher. As a result, officials are worried about misestimating inflation risks again and easing policy too soon or too soon.

On Tuesday, Fed Governor Christopher Waller said the Fed should be cautious as it begins to cut interest rates, even though inflation is approaching its 2% target. The Fed is not rushing to cut interest rates until inflation is significantly lower. This was followed on Wednesday by Dallas Fed President Lori Logan who said the Fed would need to continue to raise interest rates gradually until it sees "compelling evidence that inflation is coming back down to its 2% target in a sustainable and timely manner." "Even if the pace of rate hikes slows, financial conditions need to remain restrictive," she added. ”

Echoing Fed officials, ECB officials at this year's Davos forum also tried to delay market expectations for a spring rate cut. In an interview in Davos on Wednesday, ECB President Christine Lagarde stressed the danger of a resurgence of inflation, saying that she would "carefully watch" issues such as wage negotiations, corporate profit margins, energy prices and new supply chain disruptions, and even said that "excessive bets on rate cuts will distract the ECB."

On the same day, Klaas Knot, a member of the ECB's Governing Council and governor of the Dutch central bank, also said at the Davos forum that the market's expectations for a rate cut were "ahead of schedule" and could end up being "self-defeating". "We are optimistic that inflation will return to 2% in 2025. But there's still a lot to do to get there. "But this forecast is based on a hypothetical interest rate path that is much less accommodative than the market is pricing in." The market is betting on this, and there is a risk of self-defeating. ”

Robert Holzmann, the "hawkish" figure of the European Central Bank and the president of the Austrian Central Bank, previously said that the inflation situation is threatened, and the ECB may not cut interest rates at all this year. Even ECB officials, including ECB Chief Economist Philip Lane and ECB Governing Council member Constantinos Herodotou, President of the Central Bank of Cyprus, said on Monday that the current market expectations for a rate cut are too optimistic. Lane said the ECB will wait at least until its June meeting to assess the impact of wage developments on inflation in the first quarter for the first time.

This week's data also seems to confirm that central bankers are not "unfounded". UK inflation unexpectedly rose according to data released on January 17, with the consumer price index (CPI) rising 4% year-on-year in December, up from 3.9% in November and market expectations of 3.8%. Previously, Bank of England Governor Andrew Bailey also refuted market speculation that interest rates will be lowered soon, emphasizing that there is more market pressure to reduce inflation to 2%. Coincidentally, the US retail sales data for December released on January 17 rose by 0.6% month-on-month, double the previous value of 0.3%, exceeding market expectations of 0.4%, the largest increase in three months. The Federal Reserve's Beige Book, released on the same day, also said that almost all regions reported a cooling of the labor market.

Susannah Streeter, head of money and markets at investment brokerage Hargreaves Lansdown, said policymakers had reason to be vigilant. They face stubborn inflationary "enemies" and geopolitical risks are expanding, especially in the Middle East, where there is no end in sight to shipping delays, which could drive up commodity prices. Therefore, central banks will not rush to cut interest rates.

The market finally "disarms and surrendered"

After basins of "cold water" poured one after another, the market finally lowered its interest rate cut expectations.

In the US market, on January 17, according to the Chicago Mercantile Exchange's FedWatch Tool, the market priced in a 71.4% probability of a 25 basis point rate cut by the Fed in March, compared with an 81% probability in the previous session. Bond traders have also abandoned bets on a Fed rate cut in March, with swaps hinting at a 25 basis point rate cut in the first quarter, leaving only about 50%. The dollar index, which tracks the greenback against a basket of other major trading partners, climbed as high as 103.38, its highest since Dec. 13 last year and its biggest one-day gain since Jan. 2. The market's interest rate cut this year has also retraced from last week's 166 basis points cut to 150 basis points.

State Street's chief executive, O'Hanley, said in Davos on Wednesday that the Fed does not want to see a resurgence of inflation. "The Fed's dot plot is a very clear communication of the outlook for rate cuts this year, and I don't see why the market was betting on twice as many rate cuts as the dot plot suggested, which simply makes no sense," he said. ”

Tracy Chen, a portfolio manager at asset manager Brandywine Global Investment Management, said: "The market has also been too aggressive in pricing in the timing of the first rate cut. The Fed is more likely to cut rates for the first time in June than in March. The risk is that if we fail to have a soft landing, inflation will become stickier. The latest retail sales data also shows that consumers remain resilient. ”

In the UK market, just minutes after the latest inflation data on Wednesday, the money market for the Bank of England to cut interest rates this year from six last month to four, and the probability of five rate cuts also fell to one-in-three, while the market also fully priced in five rate cuts on Tuesday. As for the magnitude of the rate cut, the market is now pricing in a 107 basis point rate cut by the Bank of England by December, compared to 130 basis points on Tuesday and 150 basis points last month. The market has also reassessed the timing of the first rate cut, with the first rate cut expected to be in June, with bets on a May rate cut just over 50%, well below the roughly 85% a day earlier. The yield on 10-year gilts also climbed to 3.98% on Wednesday, its biggest one-day gain in nearly a year.

Jane Foley, head of FX strategy at Rabobank, said the UK data "created an atmosphere for central banks to work together to suppress market expectations of interest rate cuts." At the same time, it will also reinforce market expectations that the Bank of England will cut interest rates later than the ECB and the Fed."

European money markets have also cut their expectations for rate cuts this year, and the ECB is now expected to cut rates by 140 basis points by the end of the year, equivalent to five rate cuts of 25 basis points each. Tuesday was also pricing in a 150 basis point rate cut. The timing of the first rate cut is forecast for June, which coincides with what ECB officials hinted at. As a result, the yield on the 10-year German bund, the eurozone's benchmark bond, rose to a one-month high of 2.273% on Wednesday, and the spread between the 10-year Italian bunds and them widened to 163 basis points.

Jussi Hiljanen, head of European interest rates strategy at SEB, said: "Wednesday's move shows that the comments of ECB officials have managed to push down market expectations for a near-term rate cut. The consensus among ECB officials seems to be that interest rates could be cut for the first time in June. ”