This week in the markets: all eyes on interest rates

Investors are not as sensitive to interest rates now that it seems clear that the peak has been reached in the latest tightening cycle. But the cost of borrowing remains a key driver of financial markets and this week monetary policy is firmly in focus as the Fed, Bank of England and Bank of Japan all announce rate-setting decisions.

The ‘final mile’

Inflation has fallen fast on both sides of the Atlantic but getting down to central banks’ 2% targets is proving tough going. Last week, US inflation unexpectedly nudged higher from 3.1% to 3.2%, casting doubt on the optimistic view that interest rates are heading rapidly back to a neutral level.

Investors are starting to fall into line with the Fed’s view that it will probably only cut rates by three quarter point increments this year from the current range of 5.25-5.5%. Back in January, financial futures were pointing to as many as six or seven cuts in 2024.

This week’s Fed meeting is almost certain to deliver no change with the first cut not expected now until the summer at the earliest. It’s pretty much the same story over here, with the Bank of England, which also announces its rate decision this week, likely to sit on its hands and leave rates at 5.25%.

Inflation in the UK has fallen from a peak of 11.1% in October 2022 to 4% last month. This week, a day ahead of the Bank’s announcement, we should hear that inflation has fallen again to 3.5% and many believe that energy cuts in April will send it down to the 2% target in the spring. But - and this is a big but for the Bank - wage inflation remains sticky. Until there’s real evidence of that slowing, we will almost certainly be left in limbo by Threadneedle Street.

The third big central bank to decide on rates this week finds itself in a very different quandary. The Bank of Japan stuck with negative interest rates long after all its peers reverted to a more restrictive monetary policy. But it too is having to deal with rising inflation and the recent generous wage negotiation round in Japan suggests that the period of ultra-loose policy may be coming to an end.

Does the bull market have legs?

Aside from the interest rate question, the big unknown for investors right now is how long the unexpectedly strong bull market for stocks can continue. Having recovered from last summer’s correction, markets have been on a tear since last October and there is no sign of any let up just yet.

The S&P 500, at just over 5,100, is now 46% higher than it stood in October 2022 after a year long bear market as interest rates started to be hiked in America. That gain is not unusual in the history of bull markets and of itself is not a cause for concern. More so is the way in which valuation multiples have become more stretched.

From a low of 15 times expected earnings, the US stock market has recovered to trade at around 21 times forecast profits. That’s historically quite high and, with interest rates now not expected to provide much of a tailwind in 2024, earnings are going to have to start to do the heavy lifting.

The good news is that earnings forecasts are looking much healthier. After a modest fall in profits in 2023, analysts now expect earnings to grow both this year and next by high single or low double digits. That could bring valuations back to much less demanding levels.

Standing further back to see the current market in the context of the longer post financial crisis recovery, the bull market is looking long in the tooth but not necessarily near to its end. The 15 years of rising prices since 2009 compare with an 18-year bull market between 1982 and 2000. To use a baseball analogy, we are probably in the 7th or 8th inning of a nine inning match.

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