To cut, to hike or to hold? 2024 rates outlook and implications for FX markets

Macro-outlook: FX and rates

The macro environment of 2023 was one marked by falling inflation, subdued FX volatility and a stable US dollar. The fall in inflation pushed market participants to start predicting a cutting cycle from the world’s major central banks. Ignoring caution put forward by the leaders of these banks, market instruments began 2024 pricing base rates some 100-200bps lower at the end of 2024 than they currently are. The economic and political events due in 2024 are cause for uncertainty – almost 50 percent of the world’s population will have the opportunity to vote in 2024, including those in the world’s three largest democracies. Other many conflicts are still ongoing, with new issues arising in economically important jurisdictions. How these play out and the manner in which new, or incumbent, governments navigate these treacherous challenges will have far reaching implications, including for the global economy.

The interest rate curve is somewhat of a blunt tool when trying to gauge different macro scenarios – we believe the current pricing of cuts in the US is less of a certain path and rather an amalgamation of three different scenarios. The most likely outcome this year is a global easing cycle, driven by the US, which fails to deliver on the scale currently priced. Following this, we see a risk that the central banks must cut far more aggressively than currently priced, to address a serious global recession. And finally, we see a risk that markets have underpriced the chances of a second wave of inflation – this would result in central banks holding rates, or even perhaps hiking further. Below, we go into each scenario in more detail and what they mean for the wider macro landscape.

Scenario 1: Soft Landing – minor rate cuts

Probability: 70%

Global inflation figures made progress back toward target in 2023 – in the US we saw the Fed’s preferred measure of inflation (PCE) fall from 4.9% to just over 3%, and a similar magnitude of fall in inflation in Europe and the UK. Though this is undoubtedly a positive development and warrants the beginning of the interest rate normalization process, the current pricing in the US of near 90bps of cuts is perhaps too optimistic and there are plenty of reasons to believe inflation may stop falling, and perhaps even be floored at a level above the target of central banks. Chief among these is the continuing trend of deglobalisation – in an increasingly nationalistic world we have seen a number of political candidates run on anti-immigration platforms, the most recent success of such a mandate coming in the Netherlands late last year. This trend looks set to continue, with immigration guaranteed to be a key issue in elections across the globe. Further inflationary pressures will come from existing and new conflicts around the world – most recently the attacks in the Red Sea which have caused shipping costs from Asia into Europe to more than double. These issues will keep pressure on prices and labour markets as we move through 2024, and indeed we may already be seeing a pause in the inflation progress with the most recent numbers out of Europe and the US surprising to the upside.

In this scenario, which we see as the most likely, the Fed will cut rates 50-75bps in the second half of the year before stalling. The ECB looks likely to follow the Fed cut for cut but the situation in the UK is a little trickier. Core inflation in the UK is the highest of the three economies (5.1%) and, for now, is navigating the higher rate environment comfortably. Therefore, we may see rates in the UK persist at, or just below, current levels for all of 2024.

Scenario 2: Stagflation – rates on hold

Probability: 20%

Our second scenario is a resurgence of global inflation. The unrest in the Middle East has, in recent weeks, taken another turn for the worse – with the US, UK and a coalition of support, engaging with the Houthis near the Red Sea. Since the start of this conflict, the cost of shipping from Asia to Europe has already more than doubled, and the longer it continues the higher these costs will climb. We witnessed the dire effects of imported inflation into Europe during the beginnings of the Russia/Ukraine conflict and we could very well be on the path toward the same issues again. Should this conflict coincide with domestic economies faring better than currently expected, we could once again see inflation move higher from foreign and domestic factors.

This scenario seems more likely to affect Europe and the UK than the US. Shipping costs to the US remain largely unaffected and their generally high levels of self-sufficiency make imported inflation less of a worry. What we could see in this scenario is a divergence in US and European action – with the Fed cutting as per scenario 1, while Europe is forced back into rate hikes or at the very least, keeping rates on hold.

However, should geopolitical tensions flare up further and the US be dragged directly into any of them, we could see both a rise in inflation globally (including the US) as well as an economic slowdown and market reactions similar to those seen in the 1970s. This eventuality may well be the most difficult of all for central banks to navigate.

Scenario 3: Hard Landing – aggressive rate cuts

Probability: 10%

Though arguably a low likelihood risk, there are plenty of factors which could push the global economy toward a significant recession in 2024. One standout risk in the US economy is the current size of the deficit and the debt burden. The deficit is currently running at around 6% of GDP – approximately double the historical average – and the debt burden is a scary 125% of GDP. These numbers have been overlooked by markets for some time but that can’t continue indefinitely. The US is caught in a trap and without significant policy overhaul, these numbers look set to persist or even worsen. However, such policy action doesn’t appear forthcoming – heading into an election year it is a brave politician who runs on a ticket of serious spending cuts and/or tax hikes, if anything the opposite is more likely. Couple these factors with the quantitative tightening being done by the Fed and the outcome is a huge supply of treasuries. This supply issue could be further exacerbated in the event of worsening political tensions with China, the largest foreign holder of US treasuries. The beginnings of these issues were seen late in 2023, when the Fed had some less than stellar bond auctions. If we continue down this road, we could see a significant spike in long-term US rates. This spike, if seen in 2024, will coincide with huge amounts of corporate refinancings which will pressure labour markets and could precipitate a marked economic downturn.

The economic pressures which follow on from higher long-term rates will push the Fed to jump start a policy of support. They will look to control what they can, and this will start with cutting short-term rates significantly, possibly in the region of 200-300bps. The Fed may also look to restart quantitative easing (or at least pause quantitative tightening) to take pressure off the treasury market further down the curve. What makes this scenario a particular concern for the Fed is that there are limitations on what they can do to support. Although in complete control of the short end of the curve, they won’t be able to control a spike higher in long-term rates if a seller the size of China was to start liquidating. A panic of this magnitude in the world’s largest economy would quickly influence the rest of the global economy and ECB would be forced to follow suit with significant rate cuts. However, the magnitude of the move higher in long-term rates in these economies may, in time, be lesser than in the US. With lots of treasuries sold and this cash needing a new home, UK and German debt may, for example, start to look attractive.

As with the prospect of unwinding US treasury holdings and markets beginning to panic, FX markets are likely to react in the same way they always do in such stressed scenarios – buy the dollar. Though as the dust starts to settle, it may become clear that this market panic is not like the others – driven by a fundamental shift in confidence levels in the US as a whole, the dollar will begin to lose its shine. Following an initial spike, as portfolios begin to rebalance (for example with a move toward European and UK debt), we could see currencies strengthen against the dollar and the beginning of the end for its long held safe haven status.