Markets outpace central banks as rate cut bets fuel 'everything rally'

Markets have raced ahead of the US, euro zone and UK central banks to price in sizeable and frenetic interest rate cuts next year, fuelling a so-called everything rally that could now be vulnerable to a correction.

The US Federal Reserve on Wednesday signalled it would cut rates more than previously outlined, sending global stocks and bond prices surging as markets priced in six quarter-point rate cuts in 2024, double the number projected by Fed officials.

European stocks hit their highest in almost two years after Wall Street stocks neared a record high the day before. The benchmark 10-year US Treasury yield dipped below 4 per cent for the first time since August, while German Bund yields hit nine-month lows.

The European moves were dominated by “market pricing in the US, which is quite eye-popping,” said Chris Jeffrey, head of rates and inflation strategy at Legal & General Investment Management.

“We struggle to work out what kind of world we’re in where you have 150 basis points of cuts in the US next year without a recession,” he added, explaining that while LGIM was positive on government debt it was “not chasing the rally.”

Economists polled by Reuters expect the world’s largest economy to grow by 1.2 per cent next year.

Inflation cheer

While rate cut pricing was pared back slightly after the ECB and BoE meetings, the scale of the cuts priced in remains significant, with investors cheered by signs inflation is falling fast.

Euro zone inflation tumbled more than expected to 2.4 per cent in November, while in Britain it slowed to 4.6 per cent in October, also lower than expected.

ECB president Christine Lagarde said “underlying” price pressures were moderating more than the ECB expected.

Traders now expect the central bank to lower its deposit rate from 4 per cent to about 2.5 per cent by next December, having added more than a 50 per cent chance of an additional rate cut since Thursday. They anticipate roughly 110 bps of UK rate cuts next year, more than before the Fed and even as the BoE cautioned rates -- at a 15-year high of 5.5 per cent -- would stay restrictive.

The level of rate cuts now priced for the ECB reflected a “very very gloomy” economic and inflation outlook, said Danske Bank chief analyst Piet Christiansen.

“It seems quite an economic crisis scenario where you need to cut 150 basis points in one year,” he said, adding the risk is for government bonds to sell-off.

Rabobank warned that financial conditions had now eased “in such a rapid and significant way” that they could push economic growth and inflation higher, making central banks reluctant to cut rates.

Germany’s rate-sensitive two-year bond yield, touched 2.458 per cent, on Thursday, its lowest since March. UK two-year gilt yields, at around 4.32 per cent, were set for its biggest weekly drop since March.

Rally on

Meanwhile riskier European assets also rallied, suggesting investors in equities and high yield bonds were not concerned about the economic outlook.

“Their near term paths are probably coalescing and converging.”