Markets go into the holiday season riding high. It has been a stellar year for US and European equities while Japan has been the standout in Asia. Expectations for rate-cutting cycles are increasingly being backed up by the data - as seen in the latest inflation data in the US and UK this week. The 2-year US Treasury yield (4.32%) trades at lows going back to May while at the longer end the 10-year yield (3.89%) has retraced to 5-month lows having pressed 5% as recently as October. This backdrop has weakened the US dollar, the Australian dollar a notable beneficiary rallying by around 8% against the USD from its October lows.
Cooling inflation in the US continues to underpin expectations for a sizeable Fed easing cycle in 2024. The headline PCE deflator eased from 2.9% to 2.6% at an annual rate to November and the core deflator softened from 3.4% to 3.2%, both in below expectations and at their lowest since early 2021. Notably, on a 6-month annualised basis, the core deflator at 1.9% is now inside the Fed's inflation target for the first time since September 2020. Should this momentum continue, there is an entirely plausible scenario where underlying inflation returns to the target by the middle of next year.
Markets were left none the wiser on the timeline for policy normalisation following the Bank of Japan's meeting this week. All policy settings were left unchanged (-0.1% key rate and 0% 10-year yield target) and its forward guidance to step in with "additional monetary easing" if required has remained intact. The meeting statement conceded there are 'extremely high uncertainties' for the inflation and economic outlook in Japan, leaving policymakers reluctant to signal forthcoming policy changes. While inflation is expected to run above the 2% target through 2024, this is due mainly to the pass-through of higher imports prices and is judged as unlikely to be sustained. Underlying inflation is anticipated to 'increase gradually toward achieving the price stability target'; however, that relies upon growth picking up to an above-trend pace to underpin a rise in wages growth.
The BoE's pushback to near-term rate cuts failed to gain traction after last week's meeting, and downside surprises in the UK's inflation report for November have only added to the extent of easing priced for 2024 (rising to around 130bps from 115bps). 12-month headline inflation fell from 4.6% to 3.9%, printing at a 26-month low and well below the 4.3% consensus figure. Inflation has declined substantially from its 11.1% peak 13 months ago driven largely by falling energy prices; however, there are increasing signs that the disinflationary process is broadening to other categories of the basket. This was reflected by a decline in the core rate from 5.7% to 5.1% (21-month low) against 5.6% expected. An easing in services inflation to 6.3% (from 6.6%) rounded out an encouraging report, but the BoE will want to see far more progress in this key component through the early months of 2024.
The minutes of the RBA's December meeting get across the Board's tightening bias remains in place, but the message has been dated by recent events. Most notably, at the time of the meeting, the board members observed that 'market expectations for policy rates in other countries had eased significantly over the prior month, while being little changed for Australia'. Subsequently, those expectations have spilled over into Australia as the data have softened, with around 50bps of RBA cuts priced for 2024. The timing has meant the RBA goes into its summer break not having had the opportunity to push back on that pricing in the way the ECB (subsequently reiterated by Vice-President de Guindos) and BoE did last week.
As to the December decision, the Board elected to leave rates on hold assigning greater option value on waiting for additional data than delivering a follow-up hike to the 25bps increase in November. It was noted there had been 'encouraging signs of progress towards the Board's objectives' while the 'pace of disinflation in some other countries... had accelerated' and that if this flowed through to prices in Australia it 'would be helpful in bringing inflation back to target'. The case to hike further rested on upside risks to the inflation outlook, driven by strength in domestic demand conditions. However, the sharp slowdown in GDP growth to 0.2% in the September quarter has made this a difficult narrative for the RBA to sustain going into next year.
A Merry Christmas to all and best wishes for 2024. A sincere thank you for reading.
