Decline of UK inflation opens door to further cuts
With inflation at a 3-year low, the Bank of England might cut rates further by year-end.
Published October 18 2024
Data from the Office of National Statistics showed the Consumer Prices Index rose by 1.7% in the 12 months to September 2024, down from 2.2% in August, and below the Bank of England’s (BoE) target of 2% for the first time since April 2021. The larger-than-expected drop was led by a fall in air fares and petrol prices.
The data set off a fresh wave of speculation about where UK interest rates are heading. The BoE announced a 25 basis points cut in August that took rates down to 5%. Many investors are now speculating that there could be two further cuts before the end of the year.
“Bank of England Governor Andrew Bailey has indicated a potential shift towards a more activist approach to rate cuts,” says Orla Garvey, Senior Portfolio Manager for Fixed Income at Federated Hermes Limited.
“Recent data out of the UK supports this view, given that wages are cooling and inflation has shown a surprising downside in September,” she adds.
The euro area reported a similar fall in annual inflation on Thursday, leading the European Central Bank to cut rates by 25 basis points to 3.25%.
The unexpected fall in UK inflation will be welcome news to the new Labour government, ahead of an autumn budget which is predicted to include tax increases. Chancellor Rachel Reeves has reportedly identified a £40 billion funding black hole that will inform plans for the nation’s finances. However, the chancellor has also indicated investment will be a prominent theme of the budget and is planning a change to the fiscal rules in order to borrow more for capital projects.
“Ahead of the budget, we are closely monitoring the UK government’s actions on borrowing for this year and next, and the impact of Labour’s changes to the fiscal rule on medium-term borrowing. We anticipate the government will proceed cautiously, avoiding any aggressive changes to fiscal rules that might unsettle the market,” Garvey adds.
The ongoing uncertainty surrounding the upcoming budget, together with the BoE’s relatively hawkish stance, has caused UK borrowing costs to climb in recent weeks. The yield on the two-year UK gilt has risen almost 14% to 4% since mid-August as at 11:00 GMT on Friday. The 10-year gilt yield rose to its highest levels since early July on Monday.
“We believe the current pessimism on concerns around increased borrowing is overdone. While uncertainty will persist leading up to the budget, we expect the recent gilt market underperformance to reverse,” says Garvey.
Presidential race enters the final stretch
The US presidential election is less than three weeks away, and polling data appears to show Kamala Harris and Donald Trump tied in crucial swing states. It is far from clear who will take the White House in November, but two key indicators may shed some light on who has the better odds, from a historical perspective.
The incumbent Democrats will be judged on the performance of both the domestic economy and the stock market. Republicans will be watching for any downturns on either front that can be held up as evidence that a change of leadership is required.
“Historically, if the economy is growing strongly leading up to the election, the incumbent party retains the White House 100% of the time. Conversely, if the economy is slowing or in a recession, the challenging party regains control 100% of the time,” says Philip Orlando, Chief Market Strategist at Federated Hermes.
“Currently, we are not in a recession, nor do I believe one will be declared before election day. Therefore, we are paying close attention to metrics like the Sahm Rule, leading economic indicators, manufacturing ISM, and inverted yield curves to gauge economic growth,” he adds.
The US is on track to post the most robust real GDP growth of any G7 country in 2024, and has had the strongest post-pandemic recovery.
The other critical indicator will be stock market performance. The bull market in US stocks has now entered its third year but there are several factors other than election uncertainty – including geopolitical risk, slowing earnings growth, and weaker consumer spending, which could weigh on investor sentiment.
“Over the past century, if the S&P 500 is positive in the three months leading up to the election, by an average of about 5.5%, the incumbent party wins re-election 83% of the time. However, if the stock market is negative during these months, by an average of about 4%, the challenging party wins 83% of the time,” Orlando adds.
“Once the election is over and the associated uncertainty subsides, we anticipate a strong end-of-year rally in the stock market, potentially driving stocks to new record highs.”