Another round of central bank meetings, and another round of rate hikes. But we’re getting closer to an inflection point.
The Federal Reserve (Fed) had to tread a fine line between first, delivering what the market expected, second, not spooking the banking system and third, not losing face on the messaging that had been delivered only two weeks ago!
On the whole I thought that the Fed Chairman Powell did a fairly good job. The Fed hiked by 25bps, raising the Fed funds target range to 4.75% - 5.00% and made no changes to their balance sheet run-off plans. Many market participants interpreted the action as a dovish hike, as Powell reined back on the aggressive language of ‘ongoing hikes’ to a much more data-dependent approach. He also made reference to the fragilities of the regional banking system and the likely tightening of financial conditions for businesses and households that this could lead to. However he also quickly balanced this with a comment that how long this tightening would persist is difficult to measure as inflation remains too high and labour markets too tight.
When one delves into the detail of the ‘Dot Plot’ the median forecasts for interest rates remained little changed, but the skew of the dots have shifted higher. The committee now have higher lows and higher highs pencilled in over the next three years than at the December 2022 meeting. Reading between the lines, Powell inferred that the risks to inflation remain to the upside, and if the impending growth slowdown that the market expects is not forthcoming then higher rates will be required and the market will need to re-price. Currently the Fed Funds futures are priced almost 100bps below the official Fed funds rate and the old adage of ‘don’t fight the Fed’ rings in the back of my head.
The market reaction to the hike, perversely, saw yields push lower, however I think this move was more in reaction to Yellen’s testimony that shook risk markets in general and bank stocks specifically. She stated that the Federal Deposit Insurance Corporation (FDIC) guarantee of deposits is 'not something we are considering' which was in contrast to Powell who wrapped a fatherly arm around the shoulder of bank liquidity. My takeaway from the Fed was that they have now put more onus on their dual mandate and will be keeping a close eye on lead indicators of growth. Any slowdown in the labour market or personal consumption, as the rate increases work their way through the economic plumbing, will see the Fed move to a pause rather than a pivot. The bar to cutting rates remains very high indeed and this is one message that was very clear!
European Central Bank
Going into its latest monetary policy meeting, the European Central Bank (ECB) was faced with a tricky balancing act; inflation, while declining in headline terms, was still far higher than the 2% target, suggesting that continued tightening of policy was required to bring it back to target. However, in the run up to this meeting, tension was emerging in the banking sector, with the collapse of mid-size US bank Silicon Valley Bank (SVB), leading to fears over the strength of the global banking sector and raising memories of the Global Financial Crisis back in 2008. Does the ECB continue with its policy of raising interest rates to tackle inflation (its’ primary goal is that of price stability) or does further tightening risk introducing more stress into the banking sector? Prior to the collapse of SVB, the market was comfortably pricing in a hike of 50bps in March and further to come over the course of 2023. However, in the run up to the meeting, the market was less confident and was closer to pricing a hike of 25bps, with some talk of the ECB potentially pausing its hiking cycle altogether.
In the event, the ECB did go ahead and raise its key interest rates by 50bps, opening its accompanying press release with “inflation is projected to remain too high for too long”, but then went on to make reference to an elevated level of uncertainty and stressed the importance of a 'data-dependent approach' to policy rates going forward. This seems like a sensible approach and the fact that after the announcement and over the course of the subsequent press conference, markets were very orderly and key measures such as the Germany-Italy spreads were largely unchanged, suggesting that the market agreed. The messaging was clear; they remain determined to bring inflation back under control, but will only look to tighten further should market conditions and incoming data warrant it.
In the days following the meeting, we have seen the take-over of Swiss bank, Credit Suisse, by its larger rival, UBS, with AT1 bonds being written off, despite holders of common equity in Credit Suisse receiving some value for their shares. After an initial sell-off in European banks on contagion fears and AT1 bonds issued by European banks being marked down in price, markets appear to have been satisfied by assurances from both the European Banking Association and the ECB that the accepted loss absorption sequence of equity then AT1 bonds will be honoured in the event of any similar crises for a European bank. Notwithstanding this, in the days subsequent to collapse of Credit Suisse, Madam Lagarde and other ECB members have re-iterated that the European banking sector is in good health and there are plenty of tools and support available to ensure that European banks do not suffer the same fate. They have also been at pains to stress that they see rate hikes as a necessary tool to tackle inflation and concerns over financial stability can be addressed via other means from their toolkit. In short the ECB have now become the most hawkish of all central banks!
Bank of England
Up until 7:00am on Wednesday (22 March) morning, the market was divided on whether the Bank of England would decide to keep rates on hold at 4.00% or hike by an 25bps, particularly in light of the banking woes that have rocked financial markets over the last few weeks. Either outcome was justifiable. But the pre-market inflation data on Wednesday morning shattered that view. While inflation can be volatile, particularly on a month-by-month basis, the magnitude of the miss on the Consumer Price Index (CPI), the strength of core CPI at 6.2%, and the fact that inflation rose to 10.40% from 10.10%, rather than falling, spooked the market, and a rate hike of 25bps was all but fully priced. The Monetary Policy Committee’s (MPC) decision to vote in favour of raising rates by 7-2 therefore came as no real surprise. Market participants will of course dive into the detail of the minutes, trying to paint the hike as either more dovish or more hawkish than expected. But that is semantics; bond markets have moved beyond this. Markets are looking beyond the end of the hiking cycle, believing that central banks have tightened by more than enough already, and are pricing in rate cuts once again, starting in late Q4 2023; at the time of writing, on five-year gilts yields are 3.25%, 100bps below base rates.
In determining where central banks go from here, it is the balance between growth, labour markets, and inflation that will be central to determining the path for rates, as it always has been. It wasn’t too long ago that the MPC themselves were calling for one of the longest recessions in the UK’S history – a recession beginning in Q4 2022, and lasting a full two years. At today’s meeting the MPC consigned that forecast to history, predicting that the UK would likely avoid any sort of recession altogether. Labour markets are tight, but just as the MPC did with its growth forecasts, it upgraded its view on the labour market, seeing stronger employment growth than previously anticipated in the second quarter.
And finally, inflation. Headline inflation is high and will, in all likelihood, fall rapidly over the next few quarters. That will provide central banks with some comfort and respite. But it is the level that inflation settles at that is most important for the path of base rates, and thus bond markets. With the economy doing better than expected, labour markets not weakening as fast as hoped, and core domestically driven inflation remaining somewhat stubborn, it’s hard to see how the MPC will meet its 2% CPI target based on the markets implied path for rates. Just like many of its recent forecasts, it’s likely that its overly subdued view of inflation will be revised up, not down. UK gilts fundamentally look expensive still. Add to that the wall of supply that will greet the market from the 1 April, and I think it’s hard to see how gilt yields at 3.25% are an attractive proposition for investors.
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