Rate cut expectations shattered? Goldman Sachs: We remain optimistic

Recent central bank actions in Europe and the United States have sparked market expectations of interest rate cuts, leading to a decline in both stocks and bonds in the US. The prospects of interest rate cuts by major central banks remain uncertain.

In its latest report this week, Goldman Sachs optimistically pointed out that despite recent concerns about inflation rebounding, the overall downward trend has not changed. Additionally, the overheated labor market is gradually returning to balance, which supports the arrival of interest rate cuts.

Regarding the path of interest rate cuts by major central banks, Goldman Sachs indicated that the Federal Reserve may begin cutting rates in March, with a total of five 25 basis point cuts expected this year. However, the cuts are not as aggressive as the market expects, as the steady growth of the US economy supports a series of gradual rate cuts.

As for the European Central Bank (ECB) and the Bank of England (BOE), Goldman Sachs stated that the ECB is likely to implement a series of 25 basis point cuts in April, with a 30% chance of a more aggressive 50 basis point cut. The BOE is expected to start cutting rates in May, with a more aggressive reduction than market expectations.

Downward Inflation Trend Continues, Job Market Cools Down

Goldman Sachs pointed out that although inflation rebounded in December, the overall downward trend has not changed, and the US job market continues to cool down, with the overheated labor market gradually returning to balance.

First, let's look at inflation. Goldman Sachs believes that there is no need to overly worry about inflation rebounding:

The global core inflation rate (excluding Japan's G10 countries plus emerging markets with previous interest rate hikes) is expected to rebound from its low point of 1.2% in November to 2.6%, triggering concerns that the decline in inflation may not continue.

However, in fact, inflation is still improving. The three-month annualized inflation rate for December is expected to further decline to 2.0%, and the adjustment of core commodity prices is far from complete. In addition, it is expected that service industry inflation and wage growth will continue to gradually slow down.

In terms of US inflation trends, Goldman Sachs pointed out that they align with the overall inflation trends:

According to the latest CPI and PPI data, even with a more pessimistic assumption for categories such as financial services and non-profit organizations, the core PCE increased by 0.17% on a month-on-month basis in December, resulting in a six-month annualized growth rate of 1.9% in December.

There will be a positive "January effect" after December, which will boost the year-on-year growth rate in February. It is expected to be 2.6% in February and 2.1% in May/June. However, inflation expectations have declined, and the University of Michigan and the New York Fed's inflation expectation indicators have fallen back to pre-pandemic levels in recent months.

Furthermore, in terms of the job market, Goldman Sachs pointed out that the overheated labor market is gradually returning to balance. Despite the low number of unemployment benefit applications and the unemployment rate remaining at 3.7%, the US labor market continues to recover. In December, non-farm employment increased by 216,000, but household employment and the non-manufacturing ISM employment index both declined. The hiring and resignation rates in JOLTS are currently lower than pre-pandemic levels.

Rate cuts in Europe, the US, and the UK are expected, but may differ from market expectations

From the perspective of inflation and employment, Goldman Sachs is optimistic that rate cuts will occur in Europe, the US, and the UK, but they may differ from market expectations.

For the Federal Reserve, Goldman Sachs believes that rate cuts may begin in March, with a total of five 25 basis point cuts this year, which is less aggressive than market expectations.

The Federal Reserve will soon start cutting rates. Powell stated in a press conference on December 13th that the committee wants to cut rates before inflation falls to 2%. However, it is expected that the Federal Reserve will only cut rates five times this year, which is lower than the current market pricing of six to seven rate cuts. We also believe that the possibility of a 50 basis point rate cut is low.

This forecast is based on the combination of loose monetary policy by the Federal Reserve and sustained robust economic growth. It is expected that the US GDP will grow by 2.3% this year, with only a 15% risk of economic recession. Therefore, the possibility of a series of gradual rate cuts is greater than aggressive easing policies.

For the European Central Bank (ECB) and the Bank of England (BOE), Goldman Sachs points out that the ECB is expected to implement a series of 25 basis point rate cuts in April, with a 30% chance of a more aggressive 50 basis point cut. The BOE is expected to start cutting rates in May, with a more aggressive reduction compared to market expectations.

Against the backdrop of rising real household income and improved financial conditions, the European economy is expected to improve this year. However, it is still significantly below average, and the unemployment rate is expected to rise by 2024.

Therefore, based on inflation and economic indicators, the ECB needs to cut rates. There is a possibility of a series of 25 basis point rate cuts starting in April, and there is also a 30% chance of a more aggressive 50 basis point cut. We have priced in a higher rate of rate cuts by the ECB by the end of 2024/2025 than market expectations.

The UK policy rate is 125 basis points higher than the eurozone, and its growth is also slow, with inflation sharply slowing down. Our baseline scenario is a continuous 25 basis point rate cut starting in May, with the aim of reducing the bank rate to 3% by 2025. We have priced in a higher rate of rate cuts by the BOE by the end of 2024/2025 than market expectations.