Market attention this year has been primarily focused on central bank rate hikes and their potential end. Traders, as indicated by futures contracts, believe that US rates have reached their peak, with the expectation that the European Central Bank (ECB) will deliver only one more hike in the autumn. This view has remained largely unchanged over the past couple of months.
However, there has been a notable shift in expectations regarding the extent of rate cuts by central banks in 2024-2025 and the long-term settling point for rates. In the past month, markets have been scaling back their expectations for policy easing and increasing their projected long-term rates.
While significant rate cuts are still anticipated in the US in 2024-2025, with rates projected to fall from 5.375% to 3.75%, they are then expected to stabilize around this level in subsequent years. In contrast, US rates were mostly around 0.1% from 2009 to 2022, except for a brief period when they briefly rose above 2%.
In the Euro area, rate cuts of 100 basis points are priced in for 2024-2025, which would bring the deposit rate back down to 3%. It is then expected to remain at this level for the rest of the decade, a significant departure from the negative interest rates that were prevalent from 2014 until last year. The UK presents an even more dramatic scenario, with rates expected to peak at 6% early next year and then decline to a trough of 4.5% in subsequent years. UK rates ranged between 0.25% and 0.75% from 2009 to 2022.
This shift in expectations for the long-term level of official rates has led to an increase in bond yields over the past month. Ten-year US Treasury yields have risen from 3.75% to 4.3% since mid-July, reaching their highest level since 2009. Ten-year German bond yields have also climbed from 2.3% to 2.7% during the same period, while 10-year UK gilt yields have increased from 4.2% to 4.75%.
The rise in bond yields has put downward pressure on stock markets following their strong performance in the first half of the year. In the foreign exchange markets, the US dollar and sterling have benefited from the expectation of elevated rates in these economies in the coming years. Conversely, the yen’s decline has resumed, with official rates in Japan still close to zero.
The primary factor behind the expectation of higher rates in the long term is the diminishing risk of a recession and the growing belief in a soft landing for the global economy. In the second quarter, GDP in all major developed economies exceeded expectations. In fact, the US economy is not only avoiding a slowdown but is also on track to match the 2% growth rate recorded last year.
Additionally, unemployment rates remain at or near record lows in most countries, except for the UK where it is slowly rising. Wage growth is strong across the board, and core inflation rates are well above the 2% target level. These factors indicate an environment where central banks are likely to maintain tight monetary policies until the next global economic downturn. Market sentiment suggests that such a downturn is no longer a near-term risk, as economic growth proves more resilient than anticipated.
Oliver Mangan is Chief Economist with AIB.
