KEY TAKEOUTS

• While global inflation is heading in the right direction it remains much higher than the target of 2%.
• As much higher interest rates continue to bite, growth in the US and Europe is likely to slow, which will feed through to weaker demand and less pressure on prices – this should create a more dovish shift among central bankers someway into 2024.
• In South Africa, while domestic inflation conditions already allow for some easing in monetary policy, rate cuts are unlikely until some of the risks to inflation have diminished, including a definite end to global rate hiking cycle.

Predicting the path of inflation and interest rates has proved a chastening activity over the last two years. None more so than for Jay Powell Chairman of the US Federal Reserve Bank (Fed). In July 2021 he dismissed surging US consumer prices as transitory suggesting that “as these transitory supply effects abate inflation is expected to drop”. A little over a year later in March 2022 when inflation was nearing 8% and had been above target for a year the Fed finally began to lift rates. The 25-basis point (bps) hike in March was followed in quick succession by 50bps in May and 75bps in June. The environment had clearly changed and by July 2023, following a further series of rate hikes, Powell insisted that the Fed “will do what it takes to get inflation down”.

We’re all aware of the volatile path that ensued from that point to where we currently find ourselves. However, with the most recent inflation data suggesting that central bankers may finally be turning the tide on inflation, questions continue to mount about when we’re going to see a definitive turn in the interest rate cycle.

Falling inflation is still higher than the target

Of course, the answer to that is never straightforward. Core inflation in the US has slowed from a high of 6.6% to 4% in October. In the euro zone, core inflation peaked at 5.7% in March, but by October this had moderated to 4.2%. Other measures of inflation, including headline inflation and producer price inflation, have fallen even further. Yet, while global inflation is heading in the right direction it remains much higher than the target of 2%.

In South Africa, domestic inflation conditions already allow for some easing in monetary policy - inflation is near the midpoint of the central bank’s target and demand is weak. However, rate cuts are unlikely until some of the risks to inflation have diminished. This likely includes a definite end to the global rate hiking cycle.But, while global interest rates appear to have scaled the peak, they are likely to spend some time on the plateau. The Fed, for example, has been at pains to emphasise that it expects rates to remain higher for longer. Bond markets have taken head, with the entire curve lifting higher in both the US and Europe. Two-year bond yields, an excellent barometer for future rate expectations, are at their highest levels since before the 2008 financial crisis, pricing in the “higher for longer” outlook.

Restrictive interest rates

Given how challenging the task of forecasting inflation and interest rates is, where does that leave us when it comes to the outlook over the next year?

While there are clear risks to the near-term inflation outlook, including persistent strength in the US labour market and the recent surge in oil prices towards US$100 per barrel, what has changed is that interest rates have reset from being excessively stimulatory to more restrictive levels. In the US, for example, inflation-linked bond yields or “real yields” are well over 2%, while the real Federal Funds rate – that is the Fed Funds rate less inflation – is at 1.8% well into positive territory.

We expect restrictive interest rates will be a brake on economic activity over the next year. Banks for example have tightened their lending standards as rates have ratcheted higher. Historically this has always resulted in less lending to households and corporates. This can be seen in the chart below, which shows the net percentage of US banks’ senior loan officers who are tightening lending conditions compared to bank lending growth over the following year. Historically, lending conditions at the tight levels they are at now have always resulted in a sharp contraction in lending over the following year. We see no reason why that should be different this time round, with bank lending already slowing.

The US labour market has, of course, been a visible sign of resilience recently. For example, the latest data shows the US economy adding 336 thousand jobs in September – well above expectations. However, even here some softness is becoming evident. While September was a strong month, job creation has gradually been slowing. Year to date an average of 260 thousand jobs have been created every month – strong but sharply lower than the 399 thousand per month in 2022 and the 606 thousand per month in 2021. As much higher interest rates continue to bite over the coming months, growth in the US and Europe is likely to slow, which will feed through to weaker demand and less pressure on prices. In turn, this should pave the way for a more dovish shift among central bankers someway into 2024.

All in all, this means we are very likely close to or at the peak of the current interest rate cycle. For now, this does not mean central banks will pivot towards cuts – inflation is still too high for that. However, once growth slows more decisively in the US in 2024, it is not unreasonable to expect lower global rates at some point next year. Exactly when will be determined by at what point and how much the US economy slows in 2024.

Assessing the horizon for local rates

For South Africa, a peak in global rates would be a boon. With monetary policy restrictive, growth weak and inflation near the mid-point of the central bank’s target range, local conditions already call for easier policy. Despite these factors, immediate interest rate relief is unlikely, with the central bank remaining focused on risks to the inflation outlook. These threats include the fiscal outlook, risks to the currency and risks from higher oil prices. Looking further out, however, a peak and possible decline in global rates later in 2024 would ease the pressure on the currency and provide scope for the South African Reserve Bank to implement modest rate cuts, provided inflation remains well anchored within the target range.

As we move into 2024, the market implications of this outlook means that, while cash is currently attractive given high yields, investors will benefit from extending duration by holding government bonds and some interest rate-sensitive equities, including property shares.Globally, the likely environment over the next year will favour bonds over equities. Not only are starting yields on global bonds much higher but peaking rates will support bond prices while weaker growth will be challenging for equities.