Dot Plot Shock

Hello Traders, we hope you’re having a nice weekend. Here are some of the biggest stories this week:

• The Fed lowered interest rates but signalled a slower pace of easing next year.
• UK inflation jumped to an eight-month high.
• The Bank of England held borrowing costs steady.
• China's retail sales growth slowed, while industrial production remained strong.
• Emerging market currencies are experiencing their biggest sell-off in two years.

Dig deeper into these stories in this week’s review.

US

The Fed lowered borrowing costs by a quarter of a percentage point on Wednesday, taking the federal funds rate down to a range of 4.25% to 4.5%. However, the central bank’s latest “dot plot” of interest rate forecasts caught the market off guard. Officials penciled in fewer rate cuts for next year than they had estimated just a few months ago, and saw inflation making considerably less progress in 2025. They now see the federal funds rate reaching a range of 3.75% to 4% by the end of 2025, implying two quarter-percentage-point cuts. The Fed had previously projected four quarter-point cuts at a meeting in September. Meanwhile, its forecast for inflation at the end of next year jumped to 2.5%, from 2.1% a few months ago. The hawkish forecast led to some big market moves on Wednesday: US stocks, Treasuries, gold, and bitcoin all slumped, while the dollar surged to a two-year high.

The Fed kicked off its rate-cutting cycle in September with a big half-point cut. At the time, the central bank was encouraged by falling inflation and worried the labor market was approaching a dangerous tipping point. However, the landscape has shifted since then: the labor market and economy have proved resilient, but inflation has remained uncomfortably above the Fed’s target. What’s more, the US president-elect’s plans for steep new tariffs could spark another wave of significant consumer price increases. Fed chair Powell stated on Wednesday that the central bank is modeling and evaluating Trump's proposals but is not yet factoring them into its decisions due to uncertainty about the policies' specific details.

UK

Across the pond, UK inflation rose to an eight-month high in November, drifting further away from the Bank of England’s 2% target and highlighting the central bank's challenge in addressing persistent price pressures amid a stagnating economy. Consumer prices increased by 2.6% last month from a year ago, up from October’s pace of 2.3%. The rise was in line with economist expectations but was above the BoE’s forecast of 2.4%. Meanwhile, core inflation, which strips out volatile food and energy items to give a better idea of underlying price pressures, rose to 3.5%. Finally, services inflation – a measure closely watched by the BoE for signs of domestic price pressures linked to the labor market – remained stubbornly high at 5%.

The figures will likely reinforce fears that the UK economy is headed toward stagflation – that is, high inflation and low growth. After all, November marked the first back-to-back increase in annual inflation in over two years. Adding to the bad news, data last week showed the UK economy contracted for two consecutive months. Still, the inflation report did little to change the interest rate outlook of traders, who had already priced in less easing by the BoE next year after higher-than-expected wage data earlier in the week. The market is currently betting on two quarter-point cuts and a small chance of a third by the end of 2025. 

Speaking of which, BoE members voted 6-3 on Thursday to keep the central bank’s benchmark interest rate steady at 4.75%. Officials also warned that recent increases in wages and consumer prices had “added to the risk of inflation persistence”, dampening hopes of rapid rate cuts in 2025. Finally, following recent disappointing activity data, the BoE downgraded its economic forecast for the fourth quarter, now expecting zero growth compared to its November projection for a 0.3% rise.

China

China's retail sales growth slowed far more than expected in November, increasing pressure on policymakers to stimulate household consumption and support the economy. Retail sales rose by 3% last month from a year ago – significantly below forecasts of 4.6% and a marked declaration from October’s 4.8%. On the flipside, industrial production increased by a slightly more-than-expected 5.4%, as the manufacturing side of the economy continues to fare better than consumer spending. In fact, growth in industrial production has outperformed retail sales since the pandemic, but this may not be sustainable given that the country’s manufacturing push has seen the US and EU accuse China of flooding their markets with cheap goods, prompting threats of steep tariffs. That’s why economists argue that Chinese authorities need to urgently stimulate household consumption as a more sustainable way to propel the economy forward.

Emerging Markets

Emerging market currencies are experiencing their sharpest sell-off since the early days of the Fed’s aggressive rate-hiking campaign two years ago, driven by a surging US dollar and other idiosyncratic factors. A JPMorgan index of EM currencies has dropped more than 5% over the past two and a half months, setting it on track for its biggest quarterly decline since September 2022. The sell-off has been broad-based, with at least 23 currencies tracked by Bloomberg weakening against the dollar this quarter. The greenback has surged since late September, driven by expectations of significant policy changes under president-elect Trump, including sweeping trade tariffs.

See, Trump’s tariff plan would have three big implications for the greenback, all of which would likely see it strengthen. First, they would curb imports, resulting in fewer dollars “sold” to purchase foreign goods, which would bolster the currency over time. Second, they could push the Fed to slow its interest rate cuts or even increase borrowing costs to address rising inflation, resulting in "higher for longer" rates that would boost the dollar by making it more attractive to foreign investors and savers. Third, they could set off a sprawling, damaging trade war, ramping up safe-haven demand for the greenback.

Next week

• Monday: US consumer confidence (December).
• Tuesday: US durable goods orders (November).
• Wednesday: Christmas!
• Thursday: Boxing day!
• Friday: Japan unemployment rate (November), Japan industrial production and retail sales (November).