The Federal Reserve’s latest decision, one of the most eagerly awaited in recent memory, ended up being somewhat underwhelming for traders hoping for a more enthusiastic market response. The US central bank made a bold move by cutting its benchmark interest rate by a substantial 50 basis points, bringing it down to a target range of 4.75% to 5.0%. This marked the first reduction in over four years, and the largest in sixteen. Initially, markets reacted with a surge in equities to record highs, a fall in short-term bond yields, and the US dollar index hitting a 14-month low. However, after some early volatility, the market largely shrugged off the decision as Fed Chair Powell struck a more balanced tone, which curbed the initial rally.
Powell sought to present the 50-basis point cut as a precautionary step, rather than a reactive one due to labour market pressures. Alongside this hefty cut, the median dot plot was adjusted to reflect two further 25-basis point reductions in the next two meetings, which would bring the year-end policy rate to between 4.25% and 4.50%, still slightly above current market expectations. The unemployment forecast for 2024 was revised upwards to 4.4%, while headline inflation estimates were brought down to 2.3%. Notably, Governor Bowman dissented from the decision, marking the first such opposition from a Governor since 2005, hinting at potential divisions within the Fed. A significant portion of policymakers, in fact, only foresee one cut in 2024, differing from the median projection of two cuts.
Overall, the FOMC appears less dovish than the official statement suggests, and there may be further dissent in the final two meetings of the year. Powell’s decision to act aggressively indicates the Fed prioritises market stability over internal agreement. This is a delicate balancing act, and despite the market's initial reversal, we maintain a view that supports a bearish stance on the dollar, given that US interest rates are likely to decline more swiftly than in other major economies.
As a result of the Fed's sizeable rate cut, sterling soared to fresh two-year highs against the dollar, though GBP/USD quickly reversed from the $1.33 mark as the dollar regained ground, thanks to Powell’s careful approach. Attention now shifts to today’s Bank of England (BoE) meeting, where the consensus is that the Bank Rate will remain unchanged at 5%, consistent with the data and signals since August’s meeting. Given that markets have already priced this in, any movement in the pound could be limited.
Nevertheless, we believe the pound will continue to perform strongly against the dollar, largely due to the growing interest rate gap between the UK and the US. The BoE seems more concerned with inflation compared to the Fed. Yesterday’s jump in UK core and services inflation prompted a drop in market pricing for a BoE rate cut, falling from around 30% to 15%, with expectations for total easing by year-end reducing slightly from 54 basis points at the start of the week to 48 basis points. While we expect the BoE to hold firm today, we don’t believe the latest inflation data will prevent rate cuts in November. Services CPI has been erratic, driven mostly by base effects and price categories that seem less significant to the BoE. Coupled with signs of slowing wage growth and moderating economic activity, barring any major surprises, we anticipate back-to-back rate cuts in November and December.
In summary, GBP/USD continues to closely track the expected rate differentials between the UK and the US this year. The Fed’s outlook, given its pro-cyclicality and sensitivity to risk, seems to hold more influence over sterling’s direction. Barring any external shocks, we expect the pound to test the $1.33 level once again in the near future.
