European Central Bank holds rates but cuts inflation forecast
Today, the European Central Bank has left interest rates unchanged.
Since the last meeting in January, inflation has fallen in the eurozone, which mainly reflects a fall in energy prices. The ECB now predict inflation to fall to 2.3% in 2024, 2% in 2025 and 1.9% in 2026.
According to the ECB, interest rates will be, “set at sufficiently restrictive levels for as long as necessary.”
ECB president, Christine Lagarde said, “We are making good progress towards our inflation target, and we are more confident as a result. But we are not sufficiently confident. We clearly need more evidence and more data. We will know a little more in April, but we will know a lot more in June.”
She added that the ECB governing council have, “just begun discussing the dialling back of our restrictive stance.”
The central bank will continue to follow a ‘data-dependent approach’, monitoring inflation, and incoming economic and financial data. The two primary areas the ECB will focus on include wage growth and profit margins.
US interest rate cuts on the horizon boosts gold price
The price of gold has hit a record high, driven by expectations that interest rates in the US will be cut.
The rally was triggered by hopes that the Federal Reserve may cut interest rates. It stems from the Fed’s semi-annual monetary policy report to the US Congress, where Chair Jerome Powell couldn’t have been clearer about the direction of interest rates.
Powell said, “the Fed’s policy rate is likely at its peak for this tightening cycle.”
Investors have no doubt taken this as a victory and this will be priced into markets.
The reason why Powell painted an optimistic picture is because inflation has eased substantially and there’s been no significant increase in unemployment.
But Powell emphasised that the Committee remains, “highly attentive to inflation risks.”
Of course, that will be dependent on the economy, but it will “likely be appropriate to begin dialling back policy restraint at some point this year.”
When interest rates will fall this year is not clear, but investors are betting on sooner rather than later.
The next Fed meeting is on 20 March 2024.
UK inflation remains steady at 4%
UK inflation remained steady at 4% last month, contrary to analysts’ forecast of 4.2% and the Bank of England’s estimate of 4.1%.
Andrew Oxlade, investment director at Fidelity International, said: “Bank of England policymakers will be quietly pleased that inflation remained flat at 4% in January. The market had expected a rise to 4.2% which would have marked a second monthly increase following a rise from 3.9% to 4% in December. We shouldn’t forget that 4% is still double the Bank’s inflation target – the UK’s inflation problem is far from over.”
The largest contribution to the monthly change came from housing and household services – this was due to higher gas and electricity charges. The largest downward contribution came from furniture and household goods and food and non-alcoholic beverages.
Although inflation is expected to keep falling in the coming months, it will be the pace of those reductions that are so influential to interest rate thinking.
How rates forecasts have changed
At the start of the year, markets had been pricing in several interest rate cuts by the end of the year, possibly taking the rate down from 5.25% to 4.5%, as shown in the chart.
Those expectations had edged back in January but the latest inflation data, in particular, increased the chances of a rate cut. Traders priced in a 40% chance of a first cut in June before the inflation numbers and 65% after the data was released. The probability increased again, to 75%, after the GDP data was published.1
As of 14 February, the average two-year mortgage is 4.39% while the average five-year mortgage is 3.89%. These rates could begin to fall in coming weeks if the shift in bank rate expectations holds.
Following the inflation release, the UK 2-year gilt yield which is sensitive to interest rates remained steady at 4.5%. Meanwhile, the FTSE 100 saw a rise of 0.7%.
Current mortgage and savings rates
|
2-year fixed mortgage |
5-year fixed mortgage |
Easy-access cash account |
1-year fixed term savings account |
|---|---|---|---|
|
4.42% |
4.22% |
5.16% |
5.26% |
As of 5 March 2024
Latest Bank of England decision – the detail
The Bank of England (BoE) held interest rates at 5.25% in February, marking the highest level since the 2008 financial crisis.
The UK’s interest rate is decided by the central bank’s Monetary Policy Committee (MPC), which includes Bank governor Andrew Bailey and chief economist Huw Pill.
The MPC voted by a majority of 6-3 to maintain the rate at 5.25%. Two members preferred to increase the rate by 0.25 percentage points while one member preferred to reduce it by 0.25 percentage points, to 5%.
The bank said it would “keep under review” how long interest rates should be held at current levels, dispelling previous warnings that “further tightening” of monetary policy would be needed.
Like the Federal Reserve, the central bank said that inflation remains elevated and as a result, monetary policy will need to remain restrictive for the Bank to meet its 2% target.
At the time, Fidelity’s fixed income team said: “While market expectations for monetary policy were for a hold today, it doesn’t change our view that the Bank of England will start to ease monetary policy later this year. We would caution that rates still need to remain higher for longer in order to tame the last mile of sticky inflation but they don’t need to remain at these elevated levels.”
Dates and data to watch:
- UK labour market and unemployment – 12 March
- GDP monthly estimate for January – 13 March
- Bank of England interest rates decision – 21 March
US inflation sees a slight jump
Across the Atlantic, US inflation saw a slight rise to 3.1% last month, surpassing economists’ expectations of 2.9%.
According to the U.S. Bureau of Labor Statistics, actual prices increased by 0.3% in January, following a rise of 0.2% in December.
Following the release, the likelihood of an interest rate cut in May implied by futures markets fell from 50% to 30%, while the chances of a cut in March were “almost fully eliminated.”2
The two-year Treasury yield, which moves with interest rate expectations, increased by 0.18%, to 4.65%, marking the largest one-day move since March 2023.
Last month, Federal Reserve chair Jerome Powell said that the Fed needed more evidence that inflation would fall.
“We’re not declaring victory,” said the Fed chair. “We are prepared to maintain the current target range for the federal funds rate for longer if appropriate.”
The Fed will continue to assess a wide range of economic data releases including labour market conditions, inflation pressures and inflation expectations and financial and international developments.
How do rising and falling rates affect investments?
There are many ways that rate movements affect investments. Most people will be all-too familiar with the impact it can have on residential property prices, for instance.
But it can be nuanced. Consider the impact the recent rises had on growth and value stocks. Growth stocks, which had flourished in the era of low rates, faltered. Companies that are growth focused are often more sensitive to interest rates compared to value stocks. For example, Apple is a very growth focused company. This is because the value of Apple’s shares is determined by the value of all its future cash flows, discounted back to a present-day value. And because of the way investors value future growth, companies which are expected to have a lot of growth in the future are more sensitive to rate rises.
That’s why last year, when rates rose, growth stocks fell out of favour. Similarly, when rates fall, growth stocks become popular with investors. Even the rising expectation of falls was enough to spur a big rally in the “Magnificent 7” big tech growth stocks at the end of 2023.
Value stocks, in contrast, perform better when rates are high or rising. Consider BP. It will continue to generate profit and churn out dividends even if it’s in a high interest rate environment. That’s because its value is derived from the profits it makes today and its dividend-paying capacity.
Another consideration is the impact on money market funds. High rates have improved the rates of return on these funds, which are considered to be low risk. From the Select 50, the Legal and General Cash Trust is currently yielding 4.3%, for instance. Please note this yield is not guaranteed.
How rising and falling rates affect and mortgages and mortgage pricing?
Standard variable rate (SVR) mortgages and existing trackers tend to follow the Bank Rate, but the pricing of new deals is more complicated.
Banks and building societies lend money from deposits taken from customers but also from money they borrow on money markets.
Fixed mortgage deals are influenced by “swap rates”, be it two-year, three-year or five-year pricing, while variable rate deals, such as trackers are more closely aligned to changes in the yields on gilts, UK government debt bonds.
Since swap rates are based on what the markets think interest rates will be, if they rise, then mortgage lenders will increase their pricing to maintain their profit margin. If they rise too rapidly – mortgage lenders may have to pause lending or withdraw products until pricing stabilises.
Ashray Ohri, a lead on macro research at Fidelity, said that mortgage rates are inherently linked to the risk-free overnight indexed swap (OIS) rates, which reflect the expectations for the path of Bank rate in the future.
These changes steadily filter through to changes in mortgage pricing. A fall in swap rates in often followed by a fall in the rates being offered on new fixed mortgage deals, although this is never guaranteed given the many factors at play.
We hope to provide more information on swap pricing so please bookmark this page and watch out for updates.
UK mortgage borrowers’ sensitivity to rates
The UK central bank is particularly mindful of the impact rate changes have on UK consumers.
Some markets, such as the US and Denmark, traditionally have mortgage rate terms of 20 to 30 years. In Britain, Canada and much of Southern Europe, short-term deals pervade.
It means that in the UK, most homeowners are currently on a fixed-rate mortgage, making it the most common type of mortgage.
The Bank of England is acutely aware that millions of people will see these arrangements, some fixed at rates below 1%, coming to an end in the coming years, with those borrowers compelled to take far higher rates.
As of 5 March 2024, the average two-year mortgage is 4.42% and the average five-year mortgage is 4.22%.3
A peak in savings rates?
Savings rates, of course, are also part of this maelstrom of market pricing. The change in forward market pricing may put pressure on banks to withdraw some of the best buys on offer. Although again, these markets are volatile, and nothing is certain. Given inflation has fallen, saving rates now exceed inflation which currently stands at 3.9%.
As of 4 March 2024, the best return savers can currently get on easy-access cash accounts is 5.16%4 although higher rates are available if you tie money up for periods.
The best fixed-term savings account offers 5.26% if you lock in for a one-year fix.
And finally… annuity rates
Aside from increased savings rates, another silver lining of the recent surge in Bank Rate has been improved annuity rates. With annuities, you hand over a lump sum and received an income, often inflation-linked, for the rest of your life. These rates were appallingly low in the era of low rates but have enjoyed a renaissance. Annuity pricing is influenced by the yields on gilts. The 10-year gilt yield hit a high above 4.5% in early September and has since fallen to around 4% (15 February 2024). If you sign up to our Pulse alerts, you’ll be the first to know when forecasts move.
The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.
Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.
Sources:
1 Financial Times, 14 February 2024
2 Financial Times, 13 February 2024
3 The Times, 28 November 2023
4 Money Saving Expert, 28 November 2023
