More of the same

The three major central banks ended their 2022 with more rate rises and clear guidance that there was more to come in 2023…

Federal Reserve

As had been widely anticipated by the market, following speeches made by Federal Reserve (Fed) Chair Jerome Powell over recent weeks, the US Fed raised its Fed Funds rate by a further 50bps, following three consecutive hikes of 75bps. Recent inflation data out of the US has seen the rate of inflation come back from its highs, and has surprised the market to the downside – i.e. it has actually been lower than the market had been anticipating, perhaps showing the tightening of policy that the Fed has pursued over the course of 2022 is starting to have the desired effect.

Does this mean ‘job done’ for the Fed? The answer to this is a resounding no; despite being lower than market expectations, Core inflation (Consumer Price Index) in the US remains in excess of 7% on an annualised basis, over 5% more than the Fed’s long run target rate of 2%. With a tight labour market, wage pressures remain a key factor in the Fed’s decision-making process as it, like all central banks, is desperate to avoid a wage price spiral, further embedding excess inflation. In commentary accompanying the rate decision, the messaging was clear; whilst the pace of hikes may be reduced, the rate hiking cycle is far from over, and rates are now expected to rise to, and remain above 5% over the course of 2023. This is higher and longer than the market had been anticipating, with the Fed apparently keen to dispel any thoughts that it is softening its stance and leaving a job half done. An engineered slowdown in the economy, even into recessionary territory, may be the only solution to ensure that the heat is taken out of system, weakening labour market conditions, and finally bringing inflation back towards target.

Whether this is achievable in 2023 remains to be seen – a lesson learnt from the past few years is always to expect the unexpected and there are plenty of uncertainties remaining both in geopolitics and macroeconomic terms to ensure that this is likely to remain the case!

European Central Bank

One central bank that could not have the accusation of unclear messaging levelled at it is the European Central Bank (ECB). Like the two other major central banks that have published policy decisions over the past 24 hours, the ECB ‘downshifted’ its rate hike to 50bps, from the 75bps hike seen previously, but this hike was very much seen as hawkish. Accompanying the rate hike was a message of further significant hikes to come, for a long period of time. Furthermore, the ECB committed to a monthly program of EUR 15bn of bond sales (known as quantitative tightening) from March 2023, earlier than the market had been anticipating. The ECB’s own numbers still have inflation above their 2% target in three years’ time, even after forecasting a relatively short-lived and shallow recession. ECB President Christine Lagarde was extremely keen to put clear water between themselves and the Fed, directly rebutting a question as to the influence of Fed policy decisions over those of the ECB. On the issue of a softening of stance on policy tightening, Madam Lagarde was even more unequivocal going as far as saying, “anyone who thinks this is a pivot is wrong”.

This clear messaging gave little room for misinterpretation by European government bond markets, and 10-year yields subsequently rose by 15bps in Germany and 30bps in Italy. With a shift from central bank bond buying to bond selling, and increased bond supply as member states, amongst other things, look to fund various packages to protect their citizens from the worst of the increases in energy prices seen over the course of 2022, the outlook for European bond markets into 2023 looks very challenging. If the ECB can remain true to its word in its commitment to tackle inflation, and its forecasts prove correct, then the sell-off seen immediately after today’s decision may only be the start.

Bank of England

At today’s meeting, the Bank of England (BoE) raised base rates by 50bps to 3.5%. After yesterday’s inflation data disappointed versus expectations, a hike of 50bps was fully priced by the market and well expected. The market was also anticipating a split vote amongst committee members, given recent comments, and although the vote was 6-3 in favour of hiking by 50bps, two members voted for no further increase to rates, and one voted to increase rates by 75bps. Whilst the committee has, for much of the year, presented a relatively united front when hiking rates, large divergences amongst committee members are becoming clear, and that makes it much harder for the market to understand the Monetary Policy Committee’s (MPC) reaction function and price the path of rates from here. As we head in 2023, and an uncertain trade-off between growth, inflation, and labour markets, financial markets would benefit from a clear, coordinated, and consistent message.

What is clear is that spot inflation is high and labour markets remain tight. Although inflation is expected to fall next year, as the year-on-year impact of high energy prices dissipates, there is evidence that inflation pressures in domestic prices and wages could become more embedded and persistent - particularly if labour markets remain tighter than the BoE forecasts. The real challenge the MPC faces is not reducing annual inflation from its current lofty levels of 10.9%; it is getting it to sustainably back to an annualised rate of 2%. Given labour market dynamics, that will require further rate hikes; 4.5% is not unrealistic (see the analysis of the BoE’s decision from our Senior Economist, Melanie Baker). On this basis, and given the vast quantity of gilt supply to come next year, we believe that UK government bonds still look expensive both in their own right, and versus global markets.

This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice.