The question I get asked most at the moment is: when will interest rates peak and then start to come down?
Before I give my thoughts, let me digress a bit. Last week I was in a meeting with Lord King, ex- Governor of the Bank of England (BoE). As plain Mervyn King he had to negotiate the Global Financial Crisis – the biggest financial crisis in living memory. It was a really interesting meeting, with plenty of insights into current problems. But one thing struck me. Lord King thinks there has a been a failure in the economics profession. In essence, and this is my interpretation, central bankers have inappropriately downplayed the role of money in causing inflation. As an example, Covid and its associated effects such as lockdowns was a supply shock. The right action, as was demonstrated, was for governments to take measure to help out e.g., furlough schemes. But it was not right for central banks to increase the money supply through more quantitative easing. In crude terms, supply was shrinking and demand was being boosted. The end result was inflation.
Why is this relevant to the key question of peak rates?
It seems to me that central bankers have thrown away their ‘money’ models. Whilst I am sceptical about economic modelling, it does provide a framework for analysis. What we are left with is ‘data watching’ and policy being determined by the latest inflation prints; this is not how central banks should operate. In practice it means that interest rates will only be cut once there are signs that underlying price pressures are under control. The US will be the first to cut, probably in Q4 this year, but I think it will be later in the eurozone and the UK due to sticky wage pressures.
So, to answer the question on rates we have to address the immediate outlook for inflation. Let’s start with the eurozone. Headline inflation has come down but the core rate is staying elevated. The last reading was 5.6%, up from 3.5% 12 months ago. Wage growth looks to be robust, reflecting tight labour markets, resilient economic activity and impact of price indexation on wage settlements. Markets are looking for two more 25bps hikes by September, with the prospect of a reduction in H1 2024; this looks sensible. In the UK, headline and core rates have been sticky. The BoE wants to pause on rates, but the immediate inflation evidence is not there. Market pressure means that unless the upcoming releases are below expectations the Bank will hike again – despite forecasts of below target inflation on a two-year horizon. But once you become a ‘data watcher’ you become a hostage to fortune and markets. And market pricing is grim, with forward curves implying 5% rates by Q4. Actually, I tend to push back here; the economy will slow enough before we get there, is my sense. I see a greater prospect of a UK cut before a eurozone reduction.
The US seems in a different place
Headline inflation is falling faster and expectations of an interest rate cut are more advanced. But core inflation actually remains high. Indeed, if we look at the three areas there is not a great deal of divergence in the level of core inflation. In the US, pricing implies that rates have peaked with a Federal Funds rate at around 4.5% by year end. This however, represents a significantly higher level than was priced in only six weeks ago, during the financial panic around regional banks; at that time a rate of 3.75% was implied. The new profile now looks a lot more in tune with my thinking, but there is room for disappointment.
The weakness in bond markets last week reflected higher rate expectations – and the paring back on the timing of cuts. In the US, 10-year yields ended around 3.7%, whilst the German equivalent climbed above 2.4%. In the UK, 10-year rates went above 4% although a late rally on Friday saw yields end just below; real yields remained under pressure and implied inflation softened a bit over the week. The opposite was the case in the US where breakeven inflation saw a slight rise.
In credit markets, it was more of the same. Investment grade spreads were little changed whilst high yield risk premiums edged higher.
The impact of pension funds on fixed income
In the post-Maxwell world pension funds were encouraged, through regulation, to invest in bonds: government and credit. There is now a feeling that this has led to an under-investment in infrastructure and more growth-orientated strategies. One solution seems to be that funds should amalgamate and create pension giants that can take on riskier investments and move out of boring, low-yielding assets. If that were to occur, who is going to buy government bonds? And, if real yields have to adjust upwards, the returns investors will need on riskier projects will have to go up as well. So, a word of warning: be careful what you wish for.
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