Peak interest rates: Are we there yet?

Two central bank meetings, one immediate outcome, but two very different outlooks.

Federal Reserve

Going into the May meeting, the market had an undivided consensus on what to expect, fully pricing a further 25bps hike in the Federal Funds rate, and the US Federal Reserve (Fed) duly delivered. This was its third consecutive hike of 25bps, having downshifted from the 50bps and 75bps increments seen for much of 2022, as the Fed took steps to tackle inflation that was far in excess of its 2% target. However, this latest hike was accompanied by a shift in the messaging from Fed Chairman, Jerome Powell, hinting that the Fed could now pause, and that this may even be the last hike in this cycle.

Credit conditions tightening as a result not only of interest rate hikes but also due to the much-publicised collapse of a number of regional US banks has led the Fed to assess whether they may have done enough to tame inflation. Powell was keen to stress that going forward they will be very much driven by the data and future decisions on the path of interest rates will be made on a meeting-by-meeting basis.

However, Powell was also at pains to emphasise that inflation remains too high, and they are committed to taking efforts to return it to their 2% target and that, despite market pricing to the contrary, they do not anticipate having to cut rates soon given their view that inflation will take “some time to come down”. Powell also played down the chances of a recession in the US, preferring to forecast “modest growth” – i.e. a slowdown, rather than a contraction. Finally, he also made reference to the continued strength of the US labour market, though he did acknowledge that there had been some signs of softening of late.

So the messaging going into the meeting was clear, as was the outcome which was in line with forecasts made. This was what the market expected and as a result, there was a very orderly reaction. However, in stressing the data dependence, and an anti-consensus view regarding the likelihood of a recession, the market will now be placing even more emphasis on economic data prints out of the US, and we can expect further volatility induced by any data points that are not in line with market expectations.

European Central Bank

Hot on the heels of the Fed came the European Central Bank (ECB). Like the Fed, it elected to raise rates by 25bps and stressed the importance of incoming data when making future decisions. However, this is where the similarities ended.

Christine Lagarde, ECB President, was unequivocal in her press conference that this shift to a hike of 25bps (following a series of 50bps hikes) was a “return to a more standard” hiking increment but was very definitely not a pause, and there was more work to be done to tackle inflation.

In addition to raising interest rates, the ECB also stated that it planned to stop reinvesting the proceeds from maturing bonds bought under its Asset Purchase Program (APP) from July, having previously been partially re-investing, and only reducing purchases by around €15bn a month. The commitment to fully stop re-investing maturing bonds bought under APP, increases this number to around €25bn a month on average, and the ECB also stated that they would be looking at approaches to actively reduce their holding of APP bonds, should conditions permit.

One area where they are not looking to make any adjustments is the Pandemic Emergency Purchase Program (PEPP), which was a facility used to buy government bonds to provide market stability during the Covid pandemic. This program had far more flexibility than the APP and was skewed towards buying bonds from the weaker European economies. This remains a key tool for the ECB to keep peripheral yields under control and it committed to maintain this flexibility and continue re-investing maturing proceeds until at least July 2024.

During her press conference Mme Lagarde reiterated that the ECB is an independent central bank, and whilst they do take note of what the Fed (and other central banks) are doing, their concern is the European Union and any policy actions are taken in the interests of Europe. So whilst the Fed may be comfortable with pausing – or even ending – their hiking cycle having reached appropriately tight financial conditions to return inflation to target, Europe is not there yet and there is further tightening to come.

Notwithstanding this, central banks globally have shifted to a more 'data dependent' state, moving away from using forward guidance to prepare the market for future policy decisions. Given the increased focus on data and increased variability in data outcomes versus market expectations, volatility in markets looks set to persist, continuing to provide a fertile hunting ground for active management.

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