Guy Foster, Chief Strategist, discusses the prospect of interest rate cuts. Plus, Janet Mui, Head of Market Analysis, analyses fresh U.S. jobs data.
Another week has passed in the UK election campaign. So far, there is no sign that the polling has improved for the government. Instead, the news early last week that Nigel Farage will stand for election risks giving impetus to the Reform Party and dividing the right-wing vote further in way that stands to benefit the Labour Party. The ITV leaders’ debate seemed to be a draw in which both leaders underwhelmed. Labour holds a 20-point lead, while some polls show the gap between Reform and the Conservatives narrowing.
The performance of the economy has been improving, which would normally be a boost to the incumbent party. But with dissatisfaction over the cost of living, the ideal situation would be a reduction in inflation and interest rates that doesn’t coincide with an increase in unemployment. We have seen some increase in growth and some decrease in inflation but recently, hopes of falling interest rates have moderated, and that means that things like fixed rate mortgages are becoming
more expensive.
For the last two years house prices have become quite tightly correlated to mortgage rates and, therefore, to interest rate expectations. Good news on growth becomes bad news on mortgage costs and that in turn weighs on house prices. Last week’s data from Halifax suggest that house prices have stagnated, and mortgage rates are currently still rising.
Will interest rates fall this Autumn?
When are interest rates likely to fall in the UK? The market now sees it as more likely than not that this will happen in September or November, but that could obviously change as the economic data roll in. As discussed a few weeks ago, central banks at this stage in the interest rate cycle are inevitably data dependent.
This week will be important because of the UK employment and wage data, but last week saw the purchasing managers indices (PMIs) released, which give a snapshot of economic activity around the world.
It is notable that in the vast majority of regions, we’re seeing an increasing proportion of companies experiencing faster new order growth. The phenomenon is repeated across manufacturing and services. There are exceptions, and the UK is one of them, although that may partly reflect the disappointing weather we’ve had in late spring. But even in the UK, the services sector seems to be in good shape.
A subindex of the PMIs, which we have referenced before, is the services sector prices charged index. This has been a useful gauge because while headline inflation rates have slowed, there has been some nuance to be aware of. Goods prices have seen some significant moderation, and it could be argued that the manufacturing sector has suffered a recession of sorts after the very strong goods demand of the lockdown era. But that disinflation has been offset by sticky services sector inflation.
Across most regions, the persistence of services sector inflation is the biggest headache for central banks. It’s the reason why we might see inflation level off rather than continuing to decline. However, services sector inflation is more materially impacted by wages than other sectors. Central banks can slow wage growth by raising interest rates – in contrast to other categories of inflation, such as commodity prices, which are largely out of their direct control.
So, when the market expects fewer rate cuts, it’s largely because it’s not seeing the expected slowdown in services sector inflation. Fortunately, the services sector prices charged PMIs eased slightly and, hopefully, reflect a slowdown in services sector wage inflation.
As mentioned, commodity prices are beyond the direct control of the central bank. After rallying in the first quarter, the oil price has eased off again and that should help headline inflation decline.
Oil ‘group’ production cuts extended to 2025
The weekend before last, the Organization of the Petroleum Exporting Countries (OPEC+) discussed at a meeting held in Saudi Arabia how much oil it plans to pump in future periods. The organisation extended its “group” production cuts until the end of 2025. These are cuts that affect all members, and which had been scheduled to run until the end of this year. That news was good for the oil price because it signalled lower supply. However, there were other elements to the announcement.
Added to these group restrictions are voluntary restrictions, which are met by a smaller group of countries; OPEC+ suggested these will start to be phased out from October this year. The persistence of voluntary cuts over the summer should push the market into deficit and support prices, but there had been speculation that they would be extended to the end of the year, so it wasn’t all good news for oil.
OPEC+ aims to keep supporting crude prices while also easing production restraints that have been frustrating some members, such as the United Arab Emirates (UAE). The UAE was awarded a 300,000 barrels-per-day increase in 2025.
This puts in place an 18-month plan that does involve some increase in supply through the UAE exemption and the phasing out of voluntary cuts, but the latter is kind of data dependent and could most obviously be reviewed in August.
First G7 members cut interest rates
Although the economy and inflation have been enough to dissuade most central banks from easing interest rates, last week was a landmark for major developed markets, as it saw the first G7 members cut rates since inflation rose following the pandemic. Canada got the ball rolling on Wednesday, with the European Central Bank following on Thursday. It’s extremely unusual to see the Europeans cutting rates before the U.S. Federal Reserve.
So, when will the Federal Reserve cut rates this cycle? When the economic data suggest it is time. There were some indications early last week that time might be drawing nearer, with a sharp decrease in the number of job openings.
However, the main focus, as always, was on the non-farm payroll report, which would tell us how many new jobs were created during May. The answer was 229,000, well above the expected 180,000. Wage growth was faster than forecast too.
These data suggest that the Federal Reserve will not be cutting rates until at least September, at which point it will get perilously close to the election, when it would ideally hold rates steady to avoid being accused of interfering in the political process.
