ECB CUTS RATES AS EXPECTED BUT MARKETS ARE ALREADY LOOKING TO THE FED’S DECISION NEXT WEEK

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Data Sourced from FE Analytics, and Bloomberg Finance LP

ECB CUTS RATES AS EXPECTED BUT MARKETS ARE ALREADY LOOKING TO THE FED’S DECISION NEXT WEEK

This week’s market movements have mainly concerned next week’s decisions. The rate cut from the European Central Bank was so well sign-
posted that it could be seen by SpaceX’s billionaire spacewalkers and it only had a small effect on Eurozone government bonds while the euro rose against the dollar. Instead, it was US inflation that had the biggest effect. Headline inflation slowed from 2.9% to 2.5% and many investors see this as the final confirmation that the Federal Reserve will cut rates at next week’s meeting. However, core inflation remains stubbornly high and its slight increase month to month means expectations for a larger 0.5% cut have pretty much faded away.

In the UK, the lack of economic growth and some cooling of the jobs market, particularly lower wage inflation, helps the case for a Bank of England rate cut. At the same time, the Office for Budget Responsibility put out a gloomy forecast for government debt. This ties in neatly with the government narrative of things being so bad that something must be done, and done now, as it prepares the public for its first budget next month.

RATES: ECB CUTS AS BOND MARKETS TEMPER EXPECTATIONS FOR US CUT

Headline inflation in the US slowed to 2.5% in August. This was the lowest increase in the annual inflation rate in more than three years as petrol and used car prices fell. However, the annual rate of core inflation (excluding volatile food and energy prices) remained static, and the monthly core inflation rate picked up slightly due to rising housing costs and prices in the services sector. The decline in headline inflation means markets are confident the Federal Reserve will cut interest rates at next week’s meeting.

However, the lack of progress for core inflation means hopes of a larger 0.5% cut are fading and a 0.25% cut is seen as the most likely outcome. The likelihood of a small cut saw US treasury bonds give back some of their recent gains although they are still up on last week. The European Central Bank delivered an interest rate cut of 0.25% after CPI inflation in the Eurozone fell to 2.2% last month and GDP growth was revised down. The rate cut was widely expected but it helped push up Eurozone government bond prices as yields fell.

UK: GDP GROWTH FLATLINES AS WAGE INFLATION COOLS

The UK economy failed to record any growth for the second consecutive month as a small rise in services activity was offset by a drop in manufacturing. The UK jobs market is showing further signs of cooling. The unemployment rate fell slightly and more reliable data on earnings and hiring show that vacancies and wage inflation are falling. Low economic growth and slowing wage inflation provide more reasons for the Bank of England to cut rates. Markets expect interest rates to be left unchanged next week and for the BoE to cut in November and this helped UK gilts to rise in value.

Meanwhile, the Office for Budget Responsibility has warned that government borrowing risks becoming unsustainable. The government has been setting out the need to be prudent in advance of the budget in October. The OBR says that at current rates of borrowing UK debt to GDP will hit 274% over the next 50 years as the country deals with the cost of climate change and an ageing population.

EQUITIES: MAJOR BANKS WIN ON REGULATION BUT LOSE ON EARNINGS

The Fed cut its proposed increase to capital requirements for major US banks after fierce lobbying and threats of lawsuits. Under the revised rules major banks will still have a larger cushion against stress, but more freedom around their non-lending activities, mortgage lending and risk management. The BoE followed suit, diluting its new capital regime for banks and delaying enforcement until 2026.

The long-term regulatory win in the US was overshadowed by a sell-off of the largest US banks after multiple warnings from chief bankers about overestimating next year’s earnings. Trading profits at top US banks have fallen or remained flat, whilst income from lending will likely be lower than currently expected due to anticipated rate cuts by central banks across major economies. Conversely, laxer regulation was welcomed in the UK and major financials ended the week higher. The six biggest UK lenders have seen record profits of £48bn this year.

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