The market demands interest rate cuts

Financial markets like to go to extremes. Sales are usually excessive, which gives us an opportunity to buy, but in the case of optimism, we can also fall into too high expectations. This is the case with market expectations for interest rate cuts.

Clearly falling inflation gives room for reductions, although central banks themselves say that the fight against high prices is still ongoing, which may at the same time lead to the suppression of the economy. How does the market view cuts in the US, the euro zone or the UK?

Deflation is still visible

This morning we learned inflation data from Great Britain. Inflation fell quite deeply to 3,9% y/y from 4,6% y/y, while a smaller decline was expected to 4,3% y/y. On a monthly basis, we see a decline in inflation of 0,2% m/m, although a slight increase of 0,1% m/m was expected. Of course, there is still a long way to go to achieve the 2,0% target, because we are running out of the very high base effect, but at the same time we have increased market valuations for the upcoming reductions. Before the publication of inflation, the market estimated a 25% probability of cuts in March. Now the valuation is almost 40% and the market expects the first reduction to appear by May.

Price reductions are also increasing in the euro zone, although the boss EBC, Christine Lagarde excludes the possibility of moves as early as March. For this month, the market gives a 40% probability, but by April the market sees even a 1,5 reduction. This may be due to the publication of producer inflation in Germany. Deflation is still visible there, although it has slowed down slightly. PPI inflation in Germany for November was -7,9% y/y with expectations of -7,5% y/y, with the previous level of -11,0% y/y.

The effect is completely opposite

The market is even more extreme when looking at the United States. Of course, the fight against inflation was the best there, because CPI inflation rate for November it dropped to 3,1% y/y. The market estimates that the probability of a reduction in March is already over 75%! It's a lot. US central bankers tried to reduce the excessive market expectations after the last December decision, but the effect is completely opposite. Goldman Sachs expects the Fed will reduce rates by as much as 5 times next year! The key question regarding this forecast is whether the cuts will be related to a quick return of inflation to the target or to economic problems?

The dollar is doing quite poorly this week, although today it has been trying to make up for losses since the beginning of the session. However, the EUR/USD pair remains very close to the level of 1,10. In turn, in Poland we pay PLN 3,9500 for a dollar, PLN 4,3296 for a euro, PLN 5,0008 for a pound, and PLN 5,5853 for a franc.

Source: Michał Stajniak CFA, XTB