Our market is in a near state of paralysis or at least precariousness. It cannot be explained by the US remembering Martin Luther King yesterday because the tension in the current geopolitical hotspot of the world, the Red Sea and the Middle East is on the ascent. It appears that last week’s US/UK strike on Houthis in Yemen just strengthened the rebels’ resolve. The militant group pledged to expand its targets to US ships in the Red Sea and the heightened tension is forcing a growing number of tankers to avoid the region. Yet, what we see is a collective lack of willingness to push oil prices considerably higher although the resolute backwardation in Brent does display a certain amount of nervousness. The overnight ballistic missile attack of the Iranian National Guard on Kurdish groups in Ebril, Iraq has also failed to generate significant upside enthusiasm. On balance, it looks as though that in the absence of actual and palpable impact on oil output prices will remain well-within the current $72-$82 range even though Libyan oil output dropped under 1 mbpd because of the force majeure declared last week on the Sharara oil field.

Fast-Approaching US Rate Cuts

The efforts to bring inflation under control are in full swing and the effectiveness of central banks’ action is up for intense debate. Some would argue that lowering the cost of borrowing is not warranted yet. It would create additional demand, the thinking goes, without mitigating the pressure on supply-constrained economies and consumer prices would shoot back up. Others say that inflation, both headline and core, has been brought under control, therefore cutting lending rates in the near future would not carry risk. It is clearly visible in market expectation embodied by bond yields. The 10-yer yield in the US, for example, fell below 4% by the end of 2023 from a high of 5% 2 months before implying confidence in stable economies.

The decision to turn the monetary tightening of 2022 into something that is akin to monetary easing is certainly a delicate matter. If it comes too early, it might wake the beast, inflation that is. Being too cautious, on the other hand, might cause severe economic damage. What seems plausible is that amongst major economies the US central bank will be the bellwether that will take the bold step of lowering borrowing costs – after all it was the pacesetter of increasing it and the country’s economy is on very respectable footing. As outlined in yesterday’s note, such a step is unlikely at the January 31 meeting. The CME FedWatch Tool shows a 95% probability of US rates staying in the current 5.25%-5.50% range. The odds of cutting them by 25 basis points on March 28 then jumps to 70% and an additional 25 basis point cut is possible in May (67%) although it is lower than at the end of last week whilst the chances of staying put has increased to 25% from 17% last week but still well below the 38% registered one week ago.

The case of rate cuts is there for everyone to see. Although headline inflation rose from 3.1% to 3.4% on an annual basis in December from the previous month, the core level kept declining, albeit by the smallest of ticks. Yet, the medium-term progress has been rather remarkable. Headline inflation has descended from 9.1% in June 2022 to 3.4% and core inflation that excludes volatile food and energy prices has fallen from 6.6% in October 2022 to 3.9%.

Yet, the Fed will tread water very carefully. Its Chair, Jerome Powell warned last month that it is ‘premature’ to declare victory and progress ‘can’t be guaranteed’. Whilst it is an understandably pragmatic and even conservative approach, in the light of misjudging how far consumer prices would rise in the post-pandemic economic recovery (positive demand shock) and after Russia’s invasion of Ukraine (negative supply shock), it probably does not come as a surprise.

Whilst the successful mitigation of consumer price rises is a sanguine development the Fed’s preferred matrix is probably the PCE, the Personal Consumption Expenditures together with the state of the US job market. The latest data suggests that inflationary pressure continues to subside with the PCE Index at 2.6% in November. The labour market, on the other hand, remains resilient and maybe monetary potentates will advocate patience unless it cools meaningfully.

There is another factor, however, that might prove equally tempting to justifiably decrease the cost of borrowing in the relatively near future. It is the real interest rate, which is the interest rate adjusted for inflation. Basically, it is the nominal rate reduced by the rate of inflation, let it be expected or actual. In the era of cheap money, when lending rates were around naught with inflation running around 2% the real rate was -2%. It is undeniably a boon for economic growth, but it cannot serve as a basis for comparison. The 2010-2020 period, although it lasted a decade, was more of an exception than the norm since central banks launched an unprecedented quantitative or monetary easing programme after the financial devastation of 2007-2009. As for the here and now the current target rate has been kept in the 5.25%-5.50% range since August last year and during this 5-month period core inflation dived almost 1% - real rates effectively went up by the same amount. Should the annual increase in consumer prices remain depressed lowering rates will be vindicated or even necessitated otherwise stubbornly high real interest rates will inevitably diminish the strength of purchasing power and act as a brake on economic expansion.
 

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