Rates Spark: A 25bp cut this time, but will they pause in January?

The FOMC will deliver a 25bp cut from Wednesday's meeting. While there are arguments for the Fed to pause (inflation hiccups plus Trump policy intentions), this Fed has consistently delivered on the market discount. And where it does not like the discount, it has managed to telegraph it to the markets ahead of time. Nothing like that has happened, so expect delivery of a 25bp cut. A full preview can be found here. The key element the market will be looking for is any indication that the Fed has a tendency to pause on the rate cutting at the January FOMC meeting. We think they will; pause that is. It's unlikely they telegraph that intention explicitly. If they did it would be quite a big deal. More likely they point to a more balanced set of risks, and choose to keep their options open.

On a separate issue, the minutes from the last FOMC meeting made reference to a possible technical adjustment to the Fed’s reverse repo rate. It’s currently at 4.55%, and so 5bp above the Fed funds floor at 4.5% (with the ceiling at 4.75%). The suggestion is for the reverse repo rate to be cut by 5bp, bringing it flat to the funds rate floor. Technically what would happen is the Fed funds floor and ceiling rates would be cut by 25bp, and the reverse repo rate cut by 30bp, thus pitching the Fed funds floor and reverse repo rate flat at 4.25%. The other key rate, the interest on reserves, is currently at 4.65%, and so 15bp above the floor. This is projected to also be cut by 25bp, thus keeping spreads versus the floor and ceiling rates unchanged.

So what are the implications of all of this? There are a few moving parts here. First and foremost, the Fed’s main job here is to manage the effective Fed funds rate. This is currently at 4.58%. It generally sits between the reverse repo rate and the rate on reserves. The interest on reserves has been the most impactful factor driving the effective funds rate, which is in turn driven by the overnight cash activity of Federal Home Loan Banks. This spread has been steady at 7bp, and is likely to remain so, although if anything, the effect could be to tempt the effective funds rate lower. But on balance, we’d expect the spread to the rate on reserves to hold. That would pitch the effective funds rate 25bp lower at 4.33%.

The main outcome here is a reduced compensation for cash going back to the Fed via the reverse repo facility, which makes that facility less attractive at the margin. In turn, this continues to drive the decline in the use of the facility. That’s been the direction of travel in any case. The added benefit is the reverse repo balances head towards zero before eating into bank reserves. Ultimately as bank reserves then fall, the Fed’s quantitative tightening programme would be called to a halt. Not something to worry about though until the second quarter of 2025 at the earliest, we think.

Germany announced its issuance plan for next year, which includes €240bn via regular auction issuance, €13-15bn via green bonds and two syndicated deals including a new 30Y bond. In total this could result in a bond issuance of up to €265bn for 2025 after €276.5bn issued this year. With the finance agency flagging €191bn in redemptions, net issuance will amount to €74bn, which compares to €80bn this year. 

Largely in line with expectations, the market reaction was muted, although 10y Bunds yields did slip back below the swap rate outperforming around 1bp. The bigger picture is little changed though. Overall issuance remains on elevated levels and markets will additionally have to absorb what rolls off from the ECB's balance sheet.

UK wage growth numbers caught us and the market by surprise, rising from 4.3% to 5.2% year-on-year, reflecting a continuation of the elevated price pressures. Gilt yields, which in our view are already on the high side, rose further, with the 10Y now at 4.5%, above the UST equivalent. The push higher in yields was led by the front end of the curve, where 15bp less cuts are now priced in by mid-2025. And the upcoming CPI numbers will likely enforce the hawkish sentiment.

The pricing out of rate cuts in the UK stands in stark contrast with the dovish sentiment in the eurozone. Earlier we noted that 10Y gilt yields should find themselves lower in comparison to US rates, but also that this likely won’t happen in the near-term. Only once we see a couple of softer inflation numbers will markets be willing to calibrate the terminal Bank of England rate lower. Current pricing suggests just 50bp of cuts by mid-2025, keeping the Bank Rate at a (too) high 4.25%.