For much of the first half of the year, one of the main questions that investors were asking was how many cuts would be seen this year by major central banks. Let’s not forget, in January the US had almost five cuts priced in, with both the UK and EU also having a sharp fall in rates expected.
Fast forward to May and the rates space has been on somewhat of a rollercoaster. Although we won’t dwell on all of the twists and turns, we find ourselves in a position whereby the US, EU and UK are all still expected to cut in 2024, but at different times and at a different pace.
The below chart shows the current rate cut expectations for the three:
Such divergence is actually a good thing, as it allows traders to profit from the differences between central banks.
To that end, we share our own thoughts on rates and how we’d express these via trade ideas.
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UK
On this side of the pond is where we really see an opportunity in the rates space.
Inflation in the UK is having a much smoother road to target, shown below.
We acknowledge that the latest inflation data earlier this week was above expectations, with services inflation a bit of a concern, but we don’t see this as a major concern for the BoE.
Aside from inflation almost being at target, another key reason supporting our view for faster cuts is the state of the economy.
For example, the labour market is starting to soften. The jobless rate is now at 4.3%, up from the 3.8% from last December.
GDP growth is still anaemic, and the poor consumer confidence figures tell us that people still aren’t in a great spot.
Put this all together, and we feel there’s no reason why the US and UK should have the same rate path cycle this year.
There are two trades that can express this view, depending on the timeline.
TRADE IDEA - FASTER CUTS ARE COMING THIS YEAR
Currently there are just 21bps worth of cuts priced in through to September. This can be seen by looking at the 3m SONIA Sept contract. As a note, the way to read the chart is 100 - 94.96 = 5.04%
That’s the market implied rate by the end of the contract expiry.
For those that think we could see a couple of cuts (i.e August and Sept), the contract should be priced at 95.25. Therefore, BUYING the Sept contract would be the play here.
In terms of levels, 95.25 would be a consideration to take profit. on the downside, we see very little risk of zero cuts being priced in. Therefore, a stop loss at 94.85 (i.e 10bps of cuts) would be a level we’d cut this at.
On that angle, there’s 10bps of risk to potentially make 29bps of profit.
As a second idea, some might not want to get caught trading so short-term, but agree with our view that when the economy starts to turn, the BoE will be forced to cut swifter and faster to support an economy that’s struggling and that no longer has a problem with inflation.
In that case, we like the below expression:
TRADE IDEA - SONU4U5 FLATTENER INTO 2025
The view here is that we ignore the near term noise and just isolate the period between Sept 24 and Sept 25. At the moment, there’s just 66bps worth of cuts priced in between this period.
This can be noted by the below spread graph, which shows the difference between the 3m SONIA Sept 24 contract and the same 2025 version.
Let’s say that we do only see one cut between now and September. Are we really comfortable that from Sept for another year we’ll only see two and a bit more cuts?
This could easily start to price in more, potentially even in 50bps increments. The upside here for this trade could go to 150bps (best case).
On the downside, again we struggle to see less than two cuts, so would probably set a stop loss at 40bps. In that case, the trade would risk us 26bps while we could make 84bps.
To implement this the trade would be to short the Sept ‘24 futures and buy the Sept ‘25 futures, anticipating the spread between the two to increase.
US
Next let’s head across the pond to the US.
As a tangent, we do muse about how in the world we live in, it’s no longer the norm for smaller central banks to “follow the Fed” and wait for them to make the first move.
This equally applies to the ECB, with nations such as Sweden and Switzerland already cutting rates ahead of the ECB.
Anyway, let’s get back to business. We currently have 1.5 rate cuts priced in through to the end of the year. Put another way, 38bps worth of cuts. It’s logical to think these come in 25bps moves, and we have no reason to doubt that.
At the moment the market expects the first cut to come in November. This has been pushed back over the past month or so, based on two main factors. Indeed, our own view of how the moves happen is also heavily governed by the two interlinking factors.
Inflation
Core CPI inflation is at 3.6%, with the all items figure at 3.4%. To provide ammunition for swifter cuts, we have to see this drop below 3% (in our view). The headline figure hasn’t gone below 3% in the past year, with it bobbling around without any real trend (see below).
If we dig deeper, the underlying drivers behind the inflation print are changing. Energy prices acted as a headwind in 2022, but flipped to being a tailwind for all of 2023. Yet in the past two months, it’s now back as a headwind (granted a minor one).
