Rate cuts and the wider inflation context
Jenna Barnard, Co-Head of Global Bonds, discusses a busy week for central bank decisions and explores why the first quarter of 2025 is critical in shaping the inflation outlook and subsequent rate decisions.
3 minute read
Key takeaways:
- No surprises this week with interest rate cuts in Europe and Canada and the US Federal Reserve on hold.
- The first quarter of the year is important for gauging services inflation as these businesses disproportionately set prices in the early months of the year. How this feeds through to core inflation in the coming months will have a disproportionate impact on rate cutting cycles for the whole of 2025.
- The UK is facing some specific challenges and may prove an outlier to other developed markets as upward pressure from wages, employer tax rises and regulated price increases feed into inflation figures.
The final week of January has been a busy week for central bank decisions and communication albeit with no surprises. The US Federal Reserve opted to stand still while it assesses the prospect for inflation, while the Bank of Canada shaved another 25 basis points (bps) off its policy rate to 3%. The latter expected inflation to be around its 2% target over the next two years. It noted that business investment remains weak even as household activity perks up but conceded that the resilience of Canada’s economy could be tested if it faced significant tariffs.
Policy interest rates in major developed markets
Source: LSEG Datastream, UK = Bank of England Bank rate, US = Federal Reserve Fed Funds Target Rate (lower bound), Canada = Bank of Canada overnight policy rate, Eurozone = ECB deposit rate (January rate cut takes effect 5 February), 31 January 2022 to 30 January 2025
As regards the European Central Bank (ECB) there were no surprises as there was an element of autopilot to its decision to reduce interest rates. The cut of 25bp takes its key deposit rate down to 2.75% and a further cut in March to 2.5% feels relatively baked in. Once at this level there will likely be a raging debate between doves and hawks on the pace of further cuts. ECB President Lagarde mentioned in the December 2024 press conference that neutral was estimated to be 1.75% to 2.5%, so you can see why this debate will surface at those levels.
Lagarde expressed a high degree of confidence in the disinflation process. In her words “monetary policy remains restrictive”. Growth headwinds remain but they expect (or hope) for a pick-up driven by consumers seeing rising real wages (although that did not happen last year).
Putting it in context
The bigger picture issue for all central banks (excluding UK) in Q1 2025 will be the degree to which core inflation (which excludes volatile items such as food and energy) takes another leg down, driven by lagging/sticky services inflation. The reason that Q1 is so important for this is because services businesses disproportionately set prices in January for the full year. In the last two years, we have witnessed high services prices in this annual price setting on the back of 5%+ headline inflation the year before. As of this January, the US and Europe will see previous year prices running at approximately 2.5%.
A step down in the January pricing of services will be an important missing element in the final phases of disinflation, squeezing core inflation into the low-to-mid 2% from high 2% today. The base effects of high prices last year make a decline in year-on-year inflation rates an easier bar to meet. Progress on wages and rent inflation has already fallen into place so this is the final hurdle for most central banks.
UK as an outlier
The UK remains the outlier on all of these measures of progress: wages remain elevated with another 7% rise in the National Living wage in April 2025; a new inflation shock in the form of the recent tax rises on employers; and another round of regulated price increases (water, rail, private school fees). The starting point for core CPI (3.2% for the 12 months to December 2024) in the UK remains an international outlier before these new shocks hit.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Basis points: Basis point (bp) equals 1/100 of a percentage point, 1bp = 0.01%, 100bps = 1%.
Doves: This describes policymakers who are inclined to loosen monetary policy, i.e. lean towards cutting interest rates to stimulate the economy. The opposite of hawks which describes policymakers who are more inclined to raise interest rates to curb inflation.
Disinflation: A fall in the rate of inflation.
Inflation: The rate at which prices of goods and services are rising in the economy. The Consumer Price Index is a measure of inflation that examines the price change of a basket of consumer goods and services over time. Core Inflation are price indices that exclude volatile items, typically food and energy.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money. Monetary stimulus or loosening refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
There is no guarantee that past trends will continue, or forecasts will be realised.
Marketing Communication.
Important information
Please read the following important information regarding funds related to this article.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- Some bonds (callable bonds) allow their issuers the right to repay capital early or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the Fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may invest in onshore bonds via Bond Connect. This may introduce additional risks including operational, regulatory, liquidity and settlement risks.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit / default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- When interest rates rise (or fall), the prices of different bonds will be affected differently. In particular, bond prices generally fall when interest rates rise or are expected to rise. This is especially true for bonds with a higher sensitivity to interest rate changes. A material portion of the fund may be invested in such bonds (or bond derivatives), so rising interest rates may have a negative impact on fund returns.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- CoCos can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares/units of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- When interest rates rise (or fall), the prices of different bonds will be affected differently. In particular, bond prices generally fall when interest rates rise or are expected to rise. This is especially true for bonds with a higher sensitivity to interest rate changes. A material portion of the fund may be invested in such bonds (or bond derivatives), so rising interest rates may have a negative impact on fund returns.
Specific risks
3 minute read
Key takeaways:
- No surprises this week with interest rate cuts in Europe and Canada and the US Federal Reserve on hold.
- The first quarter of the year is important for gauging services inflation as these businesses disproportionately set prices in the early months of the year. How this feeds through to core inflation in the coming months will have a disproportionate impact on rate cutting cycles for the whole of 2025.
- The UK is facing some specific challenges and may prove an outlier to other developed markets as upward pressure from wages, employer tax rises and regulated price increases feed into inflation figures.