The experience for investors so far this year is a welcome contrast to the challenges faced last year. In January, most bond and equity indices were markedly up, resulting in our screens showing a sea of green. Perhaps, more tellingly, what is in red this year can help explain part of this optimism.
Natural gas prices have more than halved since mid-December, resulting in a better outlook for European households. Furthermore, the abandonment of zero-Covid in China has seen activity in the service sector pick up materially. As a consequence, prospects for the global economy have been revised upwards. Given the positive start, February provided an opportunity for central banks to dampen the mood as they announced their latest policy decisions.
Within a twenty-four-hour period this week, we heard from the Federal Reserve (Fed), followed by the Bank of England (BoE) and lastly the European Central Bank (ECB). A short period for the market to absorb some key messages.
In December, while the Fed slowed its pace of tightening to 0.5%, it pushed back on market optimism which had led to a loosening of financial conditions. This message was then echoed by the ECB, who indicated further rate hikes beyond what was priced in. Given that backdrop, this week investors were watching closely to see just how aggressively central banks would seek to push back against the recent rally.
Despite the Fed announcing the decision to slow down the pace of hikes to 0.25% this week, the initial messaging was that further hikes were still deemed appropriate. However, investors took comfort at the press conference when Chair Powell stated that the “disinflation process has started” and did not push back on market expectations. Previously, the Fed guided that they expect rates to peak a bit above 5% and this reaffirmed it. In the press conference, Chair Powell acknowledged the recent material slowing of the economy, and despite financial markets moving higher, tighter financial conditions appear to be weighing on business and housing investment with consumption appearing more subdued. This would imply that rates might not even reach that expected peak. Relative to last year when the Fed repeatedly revised its view on peak interest rates higher, this year it seems that not only is the summit in sight, but they might make camp earlier than expected.
The BoE message was much more convoluted. As was widely expected, they raised rates by 0.5% to 4%, marking the 10th consecutive hike. The initial headline of inflation risks “skewed significantly to the upside” made it seem that rates could continue rising beyond the 4.5% priced into markets, however, the details of the monetary policy report provided a much more dovish picture. Firstly, they dropped the guidance stating they would “respond forcefully” if inflationary pressures proved to be more persistent. Secondly, their central projection for inflation forecasts shows it moderating below 4% towards year end, with inflation below target from the 2nd quarter of 2024 onwards. While a very high degree of uncertainty surrounds the BoE forecasts, the projections would easily justify ending their hiking cycle here. Market expectations have now moderated closer to one further 0.25% hike rather than two, implying that rates could top out at 4.25% rather than the 4.5% that was widely expected.
Lastly, the ECB took the stage and came out again as the most hawkish of the major central banks. As widely expected, interest rates moved up 0.5% to 2.5%. However, they pushed back against a growing expectation that rate increases may slow to 0.25% in March by pre-committing to raise rates by 0.5%. At which point the hawkishness seemed to tail off, as they guided that further decisions would be data dependant. They justified their stance on the strength in core price pressures, which have yet to show signs of moderating despite a material drop in headline rates from double digit levels. Despite the rhetoric, expectations for rates to peak between 3-3.5% still seem appropriate.
Taking this all together, central banks are closing in on the summit which limits the ability for material hawkish surprises. The path forward for inflation over the coming quarters is lower given the base effects at play. However, forecasting beyond that timeframe remains difficult given the overall tightness in labour markets. Therefore, central banks will likely emphasise the need to stay at these restrictive levels for some time. As we covered in last week’s article Will the Fed be there for us?, the hurdle to lower interest rates from the peak is higher than in previous cycles. Hence while approaching the end of the aggressive hiking cycle is welcome, we would encourage focussing on underlying data and how that affects the central bank reaction function.
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