A mixed bag for interest rates: Stubborn inflation, reasons for optimism, and geopolitical risks
All the signs were pointing towards interest rate reductions as inflation came back under control in the US and UK, but recent figures have shown that the level remains stubbornly high. However, it’s a different picture on the opposite sides of the pond.
In the US, inflation grew more than expected in March, blamed on high mortgage and rent costs and surging gas prices. US consumer prices jumped to a 3.5% increase for the 12 months ended in March, according to Consumer Price Index data from the Bureau of Labor Statistics, up from 3.2% in February and marking the highest annual gain in the last six months.[1] Markets anticipate that the Federal Reserve will keep interest rates high until at least September in response.
In the UK, inflation fell to 3.2% in March, its lowest level in two and a half years, but still shy of the anticipated drop to 3.1%.[2] The figures show that consumer prices are still rising, just at a slower rate than last year, and real wages are still rising.
Slowing, but not fast enough
Price gains are proving much stickier in both countries than governments hoped for. This makes picking the right time to reduce the costs of borrowing increasingly difficult. If interest rates remain high, they risk adverse impacts on corporate spending and investment, with knock-on effects for stock market valuations. But central banks don’t want to turn the taps back on until they’ve tamed inflation to their targets of 2%.
US stocks fell sharply on the day inflation data for March came in. The Dow closed 422 points, or 1.1% lower. The S&P 500 lost 1% and the tech-heavy Nasdaq Composite fell by 0.8%.[3]
In the UK, the delicate balancing act for the Bank of England is in full flow. Reaction to the fall in March inflation was jubilant, with investors expecting two interest rate cuts to follow. This drove the FTSE 100 to a record closing high of 8,023 points on 22 April, followed by a new record on 23 April of 8,044.[4] That number was a fall from an earlier intraday high, however, after the Bank of England’s chief economist Huw Pill indicated that he believed rate cuts were still some way off.
The interplay between the countries raises interesting possibilities for market participants. There’s a good chance that the Bank of England drops its interest rates before the Federal Reserve across the pond, while at the same time, the pound is weakening because lower interest rates mean lower returns on investment.
A murky picture
Despite the optimism in the UK, the picture on prices is no clearer there than in the US, there are still marked uncertainties.
UK grocery price inflation, for example, fell to a 30-month low in April, pointing to a potential easing of the cost of living crisis.[1] But insurance costs, one of the drivers of US inflation, continue to rise. The Association of British Insurers (ABI) put the average increase for car cover in the UK at 34% to the end of 2023, for example, with many drivers experiencing far higher hikes, particularly for electric vehicles (EVs).[2]
Both countries are also keeping a watchful eye on geopolitical developments in the Middle East and their potential impact on energy prices. While a spirit of optimism seems to be prevailing in the UK so far, given that there’s been no escalation so far, it remains a key risk.
While plenty of market observers are willing to stake their claim to the number of rises they expect this year in the UK and the US, there remain many scenarios, including reasonable assumptions as well as outliers, that could throw off predictions.
Managing the uncertainty Last year Parameta Solutions, the data and analytics division of TP ICAP Group, the world’s largest inter-dealer broker, launched its Interest Rate Swap Volatility (IRSV) indices which provide market participants with a model-free measure of spot implied volatility in the major interest rate swap markets. Derived from unparalleled access to interest rate swaptions market data, the index consolidates all the volatility information at a specific tenor/expiry into a single measure of implied volatility.
IRSV is a model-free measure of implied volatility, and, as a recent BIS working paper[3] found, predictions of interest rate swap volatility based on model-free implied volatility have superior predictive power over other commonly used volatility forecasting measures.
With IRSV indices, market participants have a greater chance of taking advantage of favourable interest rates and managing the volatility of not knowing exactly when they’re going to arrive.
Bibliography
[1] Reuters US consumer prices heat up in March; seen delaying Fed rate cut [2] The Guardian UK interest rate cut hopes fade after inflation falls by less than expected – as it happened [3] CNN Dow closes 422 points lower after a surprisingly bad inflation report [4] The Guardian This article is more than 3 months old FTSE 100 hits record high as shares rise amid hopes of interest rate cuts [5] Financial Times UK grocery inflation falls to 30-month low [6] ABI Motor Insurance Premiums Continue to Rise as Insurers Battle Costs [7] BIS Forecasting swap rate volatility with information from swaptions
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