Happy(ish) New Year
Welcome back from the holiday season. We wish you all another prosperous year. Unfortunately, there is unlikely to be so much easy beta offered in 2025. There will still be numerous opportunities to extract juicy alpha despite market pricing broadly adopting our formerly contrarian views of high neutral rates and truncated cutting cycles for the BoE and Fed. Shocks are inevitable, as are spurious noise amplifications, so we will continue to filter for the signal, highlighting mispricing.
The ECB outlook still looks like an outlier as neither the Euro area nor the ECB’s reaction function is as exceptional as it is dovishly priced. Labour cost rises remain above target-consistent levels while activity trends broadly signal monetary policy as nearly neutral rather than too tight (see HEM: Easing Evaporating). Indeed, the EA’s unemployment dynamics are at least as tight as the Fed’s. A surprise fall in the US unemployment rate amid bumper payroll growth supports our view that it will skip January for a final March cut. Structural European headwinds are genuine but do not justify cyclical easing as priced because that would be too inflationary.
Euro area inflation increased again in December by 21bp to 2.44% y-o-y as national surprises balanced despite Germany’s shocking surge. The loss of energy price disinflation drove the headline rise while core inflation was stable, although services inflation increased to 4% again. Pressures on prices and the ECB should ease over the next two months, making the peak surmountable for another cut in January. We see risks skewed toward a policy pause then, which would match the Fed again (see EA Inflation Peak Is Surmountable By ECB).
UK interest rates have also been rising with the reassessed perception of the global neutral rate, as seen in long-term US rates. The shrinking of the BoE cutting cycle compounds the move. Although not dysfunctional, the repricing is substantial enough to cause fiscal pressures that may require a response in March to avoid breaking fiscal rules. With previous changes squeezing the private sector hard, there is a danger of replaying a socialist doom loop wherein growth suffers, raising the deficit and leading to more tax rises that further harm growth. Simultaneous falls in bond prices and the currency suggest an awkwardly rising risk premium: a theme we will no doubt return to soon.
Geopolitical pressures neither help the UK nor the inflation outlook. The threat of trade wars also makes forecasting the oil price unusually hazardous. However, based on the ‘known knowns’, Alastair Newton believes the downward pressure we saw through 2024 will persist. Therefore, his yearend forecast for Brent crude is USD65 per barrel (see Oil in 2025).
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Inflation Forecasts
The UK’s inflation rate in December is highly sensitive to airfares, which are incredibly volatile given surge pricing around the Christmas holidays. The ONS’s choice of index date determines whether the trips sampled will be attractively timed around Christmas and so expensive, like in 2023. The December 2024 index date is instead highly likely to be the tenth, meaning all UK and European flights in the sample depart while schools are in session, returning before Christmas. Historic examples confirm this to be a cheap pricing regime. The consensus often misses such things, so our 2.6% y-o-y CPI inflation forecast will likely be below many forecasts elsewhere.