In the three-horse race against inflation, who is in a commanding position and who is trailing behind?
The recent central bank meetings highlighted that the sprightly Jay Powell is still firmly sprinting toward the finish line, with Madame Lagarde gracefully gliding along behind and slowly closing the gap, however poor old Andrew Bailey seems to still be lacing up his trainers, missing the point that this is a sprint rather than a marathon!
European Central Bank
The European Central Bank (ECB) hiked 75bps, as expected, raising the refinance rate to 2.00% and deposit rate to 1.50% while continuing to signal further rate hikes ahead. They also changed the terms and conditions of the third series of targeted longer-term refinancing operations (TLTRO) and reduced the remuneration of reserves. The forward guidance focused on the return of inflation to its 2% target and that the future policy rate path will be assessed on a meeting-by-meeting approach. This was slightly less hawkish than in September 2022 when they referenced raising rates over the next few meetings although this phrase did reappear in the following press conference.
Madame Lagarde clarified that they have made substantial progress in withdrawing monetary policy accommodation, however in contrast she stated that they still had ground to cover and this may require them to raise rates above the neutral rate to deliver the 2% target. She reiterated that the focus is firmly on inflation and that higher rates will help to address the demand supply imbalances. Perhaps an obvious statement, but clarification that they are nowhere near done on rates yet. In terms of the TLTRO and remuneration of reserves changes, these just helped to grease the liquidity wheels and on the topic of quantitative tightening the short answer is “nothing to see here”… for now.
The initial market reaction saw yields fall, led by the front end, as the market was surprised by the slightly less hawkish stance, however this was seen as an opportunity to sell bonds and since the meeting we have seen yields across the curve generally move back to pre-meeting levels. The one area that benefitted was breakevens which have moved higher on the anticipation that a slower pace of hikes may continue to embed a higher inflation path. This thought process was rubber stamped by a series of strong inflation prints post the ECB meeting across the eurozone.
After the well telegraphed 75bps hike to 3.75-4.00% for the federal funds target range, it was expected that Powell would prepare the market for a slower pace of rate hikes. However, the market was caught by surprise as Powell was keen to emphasise that it was premature to talk about a pause and that rates need to be raised further than they expected. He said that there was still “ground to cover” and “cover it we will”. Hence while it might be reasonable to think that the Federal Reserve (Fed) will hike less than 75bps in December 2022, at the moment it sounds as if the terminal rate in their median forecasts when they publish them in December 2022 will be higher than the previous 4.6%.
They did highlight that they have tightened a lot already this year (375bps) and that they were aware that there is a lag between hikes and the transmission mechanism, but like the ECB they reiterated that returning inflation to 2% is the only game in town. The recent data continues to be strong and implies a higher path of rates is still the direction of travel. The Fed highlighted that the risk is not of overtightening policy but of not doing enough!
Prior to the meeting the market had got quite excited about a Santa 'pause' in rates, but Mr Grinch (Powell) knocked this on the head citing that the longer inflation remains in the system the more it will become entrenched and therefore don’t expect rate cuts (or a pivot) any time soon.
The US treasury market took this negatively, despite Powell doing a reasonable job of threading the needle without a stampede for the exit door. Front end treasuries rose 15bps and the market now anticipates that Fed funds will peak at just over 5% in 2023. The yield curve flattened as longer dated bonds continued to price in the chance of a recession in 2023. Breakevens remained relatively unchanged as the Fed remained firmly on the front foot in their war against inflation.
The Bank of England
As expected, the Bank of England's (BoE) Monetary Policy Committee (MPC) hiked rates 75bps to 3%. The vote wasn’t unanimous though, and dissent was all in a dovish direction with one vote for 50bps rate hike and one for 25bps rate hike. They signalled more rate hikes to come, but not as many as the market has priced in (when it was expecting a peak of 5.2%).
The Bank continues to have difficulty in giving a clear message on policy direction and their press conference once again came across as muddled and lacked a forthright focus on tackling inflation head-on. The monetary policy report that accompanied today’s decision had to make a few assumptions about the fiscal (or lack of fiscal) support that will be coming to the economy but also stated that this could all change again on the 17 November when the chancellor delivers his Autumn statement. Lastly, in the press conference the speakers referred to three different market peaks and could not clarify to journalists which peak was too aggressive. Just another example of poor messaging which adds to their continuing lack of credibility.
Taking the forecasts and their body language at face value you could ask why are the Bank raising rates at all? On a constant interest rates basis (at 3%), the report shows the consumer price index is only a little above target in two years’ time and more than a percentage point below target at the end of the third year of the projection. Yet in the press conference they cited inflation risks are skewed to the upside, domestic inflation is strong, wages are rising and household inflation expectations remain elevated. All of which left market participants scratching their heads yet again.
In conclusion, we felt that this was just another garbled message from the BoE that remains at the back of the pack in the race to fight inflation. As a result, the gilt market reacted by pushing long yields and breakevens higher and sterling lower as a sign that they continue to lack confidence in the ability of the BoE to bring inflation back to target.
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