Have rate cut expectations gone too far?

• Markets ended 2023 on a solid footing: Markets cheered as central banks held rates at the end of 2023 and priced in more rate cuts for this year. These dynamics bolstered equity markets, which continued to rally towards year-end. The top performers across the year were in developed markets – US and Japanese equities in particular. These outperformed emerging market equities, which were dragged down by the struggling Chinese market. Bonds also performed well in December. Notably, last year’s rise in government bond yields was erased in the US and the Eurozone – both falling back to levels seen in January 2023 – as the focus shifted away from rate rises towards rate cuts.
  
  
• A more cautious 2024 start: However, the market rally in December stalled in the first week of 2024, with many major equity indices falling. Perhaps expectations of rate cuts have gone too far. Indeed, following a stronger-than-expected US jobs report, US Treasury yields rose again, with the 10-year benchmark increasing above 4% once again. Similarly, in the Eurozone, an inflation acceleration, while expected, led to European bond yields trending higher, too.
  
  
• (Almost) all central banks held rates in their last meetings of 2023: As expected, the US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) kept interest rates at their current levels. The Central Bank of Norway (Norges Bank) was an outlier raising its policy rate, although it may be the last one in this cycle. The USD weakened, driven by the change in the Fed’s tone, while the Norwegian krone outperformed given Norges Bank’s latest decision.
  
  
• Turning to rate cuts: While the ECB and BoE pushed back at any rate cut expectations, the Fed seems to have turned more supportive, acknowledging that the economy is slowing. This marks a significant shift from the past two years when fighting inflation was the top priority. The Fed pencilled an extra rate cut in their projections for this year (three in total). Meanwhile, the move out of negative interest rate territory by the BoJ is on the cards in 2024, but the timing remains quite uncertain.

• Beneficial portfolio changes: The rise in government bond prices (as yields fall) since November has been positive for portfolios given our recent increased position (though the most recent rise in yields means that we partly gave back some of the gains), as described in our 2024 Investment Outlook. Within equities, we recently reduced our underweight stance in equities in anticipation of these rate cuts.
  
  
• Slightly increased equities to mitigate underweight: We continue to hold low-volatility stocks and, generally, high-quality stocks with strong balance sheets. We have also increased our exposure to European equities (excluding the UK) and developed Pacific equities (excluding Japan).
  
  
• Government bonds are attractive: As evident from the last few weeks’ market movements, the expectation of interest rate cuts in 2024 has caused bond yields to fall (and prices to rise), which is positive for our overweight position. We have kept exposure to longer-dated, high-quality government bonds in the Eurozone and have bought more US Treasuries.
  
  
• Reduced riskier credit: Given the lower risk yield available in government bonds, we have reduced our exposure to riskier credit.
  
  
• Added broad commodities: We are diversifying our commodity exposure into a broader allocation, which can help protect portfolios from any short-term uncertainty in geopolitics and energy prices and as capitalise on any upside surprise in growth. 

• Interest rates to decline, but gradually: We believe our forecasts of moderate rate cuts totalling one percentage point (ppt) continue to make sense relative to the market’s anticipations of 1.5 ppts. We haven’t seen a broad-based weakening of economic data in the US that would warrant so many rate cuts. There are pockets of weakness, such as last week’s US ISM surveys for the service sector. Still, the economy remains relatively resilient, as yet another stronger-than-expected labour market report showed.
  
  
• The Eurozone is likely in a recession: The weak 2023 October, November and December Purchasing Managers’ Index prints and a contraction in economic growth in the third quarter of 2023 likely confirm our base case scenario of a mild technical recession in Europe.
  
  
• The last mile to inflation normalisation looks uncertain: Last week’s inflation in the Eurozone rose to 2.9% in December. but that was slightly less than anticipated. Although core inflation (excluding food and energy prices) fell, the overall inflation figure raised questions about how quickly the ECB will start cutting interest rates.
  
  
• US inflation, Taiwan election: This week, the focus is on the US, with inflation also expected to have risen (Thursday). Here, too, the general trend is one of inflation moderation and, over time, interest rate cuts. Elsewhere, the markets may watch for headlines on Taiwan’s election, its relationship with China, and any US comment. This could create some volatility in line with our fragmented worldview.

Past performance is not a reliable indicator of future returns.