Market View

Have the hawks managed to dust the snow off?

Following a year that most investors would be happy to dismiss to the history books, this week marked the last gasp before holiday trading starts to set in.

Royal Exchange
Jeremy Sterngold, Deputy Chief Investment Officer

Not only did we receive important economic data releases, this was also the last chance for central banks to recalibrate policy in 2022. The shift in stance over the past twelve months has been remarkable in the context of the last few decades. This time last year, the three major developed market central banks were all still buying government bonds and expanding their balance sheets with only the Bank of England (BoE) raising rates by a meagre 0.15% to 0.25%. Where we stand at the end of this week is a rather different picture.

At its meeting on Wednesday, the Federal Reserve (Fed) announced that rates would increase by a further 0.5%, moving rates up to the 4.25 – 4.5% target range. This marked a step down from the four previous increases of 0.75%. Consequently, the cumulative tightening over the past nine months is a rather aggressive 4.25%. By way of comparison, this is the same level of increase that the Fed undertook in its hiking cycle between 2004 to 2006. The guidance that they would slow down the pace of hikes, paired with the recent softening of inflation in the US, has supported markets since mid-October. This has coincided with a decline in treasury yields and inflation expectations, while the improved conditions for corporate bonds and equities prompted a loosening in financial conditions. Thirty-year mortgages are a case in point, they peaked at that time around 7% and have since come down to closer to 6%.

This meeting gave the Fed the opportunity to push back against the recent loosening and Chair Powell tried his best to come as hawkish as possible. He stated that the medium projections for rates in 2023 were above 5% and the committee expected them to stay there throughout 2023 before slowly moderating in the subsequent years. This was supported by their forecasts, showing that Core PCE inflation, their preferred measure, is expected to average 3.5% next year compared to their 3.1% forecast in September. Furthermore, Chair Powell expressed that peak rates have, in the past, been revised upward, and could again.

Powell also stressed how the tight labour market could make inflation stickier, justifying the decision to keep monetary policy tight. However, given the last two monthly CPI inflation releases undershot expectations, investors did not seem to take a lot of notice of the hawkish rhetoric. Credibility may explain part of it but also the trajectory of rates. While the Fed has tried hard to re-establish its inflation fighting credentials, its forecasts seemed to lack credibility to the market. Inflation expectations, as measured by several indicators, show little sign that the neither the market nor consumers have changed their longer-term view of price pressures, so the Fed can claim victory there. However, their forecast that growth would average 0.5% next year seemed overly optimistic compared to the increase in unemployment from 3.7% to 4.6%. Looking back through history, whenever the unemployment rate rises by 0.5% or more, the US is typically in recession. As such, the market expects the Fed to change course faster than their forecasts as a result of a weaker economy.    

While the Fed struggled with its hawkish credentials, the European Central Bank (ECB) looked to take the mantle. It joined the BoE and Fed with a 0.5% increase in rates, but its messaging was much clearer cut. The ECB only stopped buying bonds at the end of June and started hiking interest rates in July. It moved from a negative deposit rate of -0.5% to 2% yesterday, representing a cumulative tightening of 2.5%. Despite this brisk pace, they came out and stated that rates will “still have to rise significantly” and at a steady pace. During the press conference, President Lagarde clarified it further by stating that the steady pace meant that they foresee the pace of 0.5% per meeting as the correct one and that it would be more than one meeting. This implies that rates in the Eurozone would need to move at least to 3% from 2% currently. Relative to market pricing indicating that rates would peak at 2.75%, this represented a big hawkish shock. As a result, two-year German bunds rose 0.22% yesterday, their largest daily increase since 2008 with equity market falling as a result.

Furthermore, they also announced how they intend to reduce their holdings of bonds. They expect their holdings to decline by €15bn a month from March until the end of the second quarter and determine the pace following that over time. From slow and steady to sharp and large, the change in central bank tone and action has been stunning. While the words of the Fed rang hollow, the ECB managed to dust off the snow and release its hawks. Ultimately, given the magnitude of the interest rate increases, we are closer towards the end of the hiking cycle. The ECB was the last to start, so as market expectations have come down, it needed to firmly push back on them to reassert its own inflation credentials. Given where bond yields sit today, the advantage will be that as economies slow down alongside demand led price pressures, bonds are much more likely to resume their role as a diversifier.  

On a more personal note, I would like to send my best wishes to our outgoing CIO, Jonathan Marriott, who has written many of these weekly briefs. My colleagues and I would like to thank him for all his hard efforts over the years, his frequent use of historical references and love of a good conversation over a cup of coffee will be missed.

Finally, we would like to take this opportunity to wish all of readers a Merry Christmas, Happy Hanukkah and enjoy the holiday season.


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