One thing I find useful to have in my head – not least for my own selfish personal finance reasons – is where UK interest rates are expected to settle when the current cutting cycle is over. The answer today is around 3.0%-3.5% for the UK and US by the way (and around 2% for our Euro clients). When I tell people these numbers (which is the market view, not mine by the way) I sometimes get the pushback that the markets have been consistently wrong on this since 2021 (and often before then) so why would they be right now? Remember in 2021 the markets thought the UK base rate would stay below 1% basically forever!
My answer is that the markets have, on average, been better than any forecaster, guru, newspaper columnist or fund manager I know. Most people thought rates had to rise from the 0% floor in the 2010s. They didn’t. And most of the people who were finally proved right when rates and inflation did take off in 2022/23 had spent a decade being wrong before that. And a decade is a long time to be wrong when managing other people’s money!
But all this sounds a bit salty and defensive. First, if you do know someone who called it right, please let us know who they are. It would be great to meet them! Second, the best way to think about markets is not deterministically (this will definitely happen) but probabilistically (there a few scenarios, how likely are they and how will I do if one of them happens). In this light I think there are three scenarios worth thinking about for UK and US rates (and for whatever financial planning you are doing):
- Growth stays strong, inflation is OK but remains above 2%. This is where we were for parts of 2023 and early 2024 by the way. In this scenario rates are higher for longer and maybe the UK base rate is in the 4%-4.5% range.
- Growth stays strong or at least stable and inflation continues to slowly fall back to target. This is the “goldilocks” scenario which is, more or less, where we are today. Part of the reason for optimism on inflation is that many of the things that make it above target today (housing, wages, car insurance) are by definition, backward looking. This means they should keep slowly falling into 2025. We shall see but this remains my most likely outcome. This is where we end up with 3% to 3.5% rates.
- Growth slowdown or recession. I think with the inflation genie back in the bottle central banks can cut rates quickly and being back at 1% or so in short order is not out of the question.
To visualise this, here are the probabilities Goldman Sachs attach to each of these outcomes. This is for the US but the UK is not that different. You can take off around 1.5% for the Euro scenarios.
So you can think of the 3%-3.5% range as being the most likely outcome (as I do) or, if you prefer as the mid-point of two other possible scenarios (recession, inflation remains a problem). Either way this range makes sense to me.
The robustness of this approach was brought home to me this week when we saw initial jobless claims spike higher in the US (raising recession risk) and inflation come in hotter than expected. Interest rate markets barely moved. If rates markets are, more or less the mid-point of two different scenarios that make sense.
For the record, we still think the most likely risk is recession here. I wouldn’t say we are bearish on the economy but a slowdown still looks more likely to us than re-igniting inflation. I think any long term inflation issues would most likely come from wages staying too high. Here is the latest wage data from the US:
One striking feature is we just have not seen wages chase inflation higher and cause the kind of wage/price spiral we saw in the 1970s. If wages continue to follow falling inflation lower with a lag there is reason to be optimistic on this for 2025. Traditional investing is (more or less) equities with bonds as hedge. This hedge failed very conspicuously in 2022 when bonds and equities fell together. It has, however, been working much better as an approach since then. And there is reason to hope it will keep working into 2025.
Chris Brown, CIO
cbrown@ipscap.com
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