European Central Bank catches market by surprise

From an economic point of view, the story of 2022 has shifted from a focus on inflation, to what central banks will do on interest rates. In the past week we’ve seen changes from three of the four most-watched central banks.

European Central Bank

The European Central Bank (ECB) took the market by surprise at its July meeting, increasing its interest rates by 50bps, having previously guided (and re-stated when challenged on a number of occasions) that its first rate hike in over 11 years in July 2022 would be limited to 25 bps. The corollary to this was that it abandoned further forward guidance, and joined other central banks in moving to a more flexible, data dependent model while acknowledging that inflation remains well above target and, in the absence of weaker inflation forecasts, more rate hikes are likely. It also introduced, albeit somewhat opaquely, its tool to tackle ‘fragmentation’ within the eurozone, which it has labelled the ‘Transmission Protection Instrument’ (TPI).

The TPI tool is intended to tackle unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area, though details of what constitutes “unwarranted, disorderly market dynamics” remains somewhat vague and is at the discretion of the ECB. The market initially sold off aggressively on these announcements, as the degree of tightening exceeded market expectations and the lack of detail, even when questioned in the press conference, on the conditions under which the TPI would be employed, caused it to take fright. However, by the end of the day of the announcement, yields were lower and spreads tighter, as the market shifted its focus to fears of future recession, possibly exacerbated by the tightening of financial conditions that the ECB had just announced. With a previously unanticipated election in Italy to come in September, accompanied by electoral pledges to tackle the cost of living squeeze, we may well yet see how effective the new anti-fragmentation toolkit of the ECB actually is before the quarter is out.

Federal Reserve

In contrast to the ECB, the Federal Reserve (Fed) produced few surprises. At its meeting on 27 July, the Fed raised rates by 75bps, its second consecutive hike of this magnitude, taking its benchmark overnight rate to 2.5%. As has been the case in all of its recent meetings, the Fed focused on inflation as its biggest topic of concern. Jerome Powell was clear that another unusually large hike in September may be appropriate should underlying price pressures remain persistent. The reaction from the market was relatively muted, with the Fed continuing to deliver a clear and concise message: it will continue to act decisively to ensure inflation expectations are kept under control. The Fed is not done yet!

BoE

On 4 August the Bank of England (BoE) raised interest rates by 50bps, its largest hike in more than 25 years. Having raised rates by 25bps at each of its previous five meetings, this was a step up in messaging from the Bank. Having already seen the ECB raise rates by 50bps and the Fed increase rates by 75bps for the second meeting in a row, the market was very much priced for the step-up in the BoE’s rhetoric. The Bank was also very clear in its messaging on both inflation and the economic outlook: inflation is expected to remain high in the short term with inflation peaking around 13% later this year, before returning to its 2% target in two years’ time.

Whilst recent economic data, particularly relating to growth, has been weakening, the BoE’s forecast that the UK would go into recession, and experience five quarters of negative economic growth in a row, starting later this year, was a negative shock. The environment for the consumer will clearly not be getting any easier any time soon. And the monetary policy tool kit didn’t end with just a hike in rates. With the BoE uncomfortable about the size of its balance sheet, the Bank will look to begin active quantitative tightening (QT) by selling bonds back to the market, starting as soon as September. Again this was fully expected by the market, and the BoE is now the first of the major central banks to start active bond sales. When combined with passive QT (no longer re-investing the proceeds from maturing bonds back into the bond market), the BoE’s balance sheet will decline by around £100 billion per annum. The hope is that this will inject some much needed liquidity into bond markets. But there are risks; the decision to start actively selling bonds now could coincide with increased government expenditure and thus borrowing. And finally, in line with other central banks, the BoE has abandoned forward guidance, and will be moving to a data driven, meeting-by-meeting decision making panel.

Summary

It has taken a while, but all major central banks other than the Bank of Japan have now joined in the party. Central banks are lifting rates to combat extremely high spot inflation, which if not tamed, risks feeding into inflation expectations at a time when labour markets are tight. But risks are emerging, particularly for the BoE and ECB, who are now raising rates by historically high increments into a deteriorating economic growth backdrop. The UK in particular is suffering from a significant cost of living crisis, which will only be compounded by rising interest rates. Markets remain extremely volatile as a result, an environment that we believe presents opportunities for active managers to add value.

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