How is the market reacting to global rate hikes?

 

After its meeting on Wednesday, the US Federal Reserve (Fed) announced a 75bps hike to interest rates – its largest single move since 1994.

A day later, the Bank of England and Swiss National Bank followed suit, lifting rates 25bps and 50bps respectively. Meanwhile, the ECB is all but certain to raise rates at its July meeting.

With rate hikes coming in either larger or sooner than expected (or both), volatility has spiked in risk assets and yields on government bonds alike.

To put things into perspective, in June so far 2-year US Treasury yields have moved up nearly 1%, 2-year Bund yields have nearly trebled (moving from 0.45% to 1.22%), and 2-year Gilt yields have gone up 50bps to nearly 2%.[1]

At the same time, the amount of global outstanding debt with negative yields has more or less collapsed, as the chart below shows:

 

So, with the market appearing to be undergoing a radical shift in regime and money becoming the most expensive it’s been for years, what can investors take away from these dramatic developments?

 

 Everything is… under control?

A 75bps hike might be the biggest move in decades, but the Fed has failed to convince the market it has things under control.

Over the next few months, we expect global inflation to remain high and inflation expectations to trend yet higher. This means that when the FOMC (Federal Open Market Committee) next meets in late July, we anticipate it will once again be forced to deliver a large rate hike.

Between then and now we expect USD interest rate curves to remain very flat and risk markets volatile because, as long as the Fed looks behind the curve, it’s very hard to believe this ends well.

Turning to Europe, the ECB this week took an important step towards raising rates at a faster pace by attempting to address the widening of peripheral spreads. 

Scepticism about its ability to pre-emptively counter spread moves was tested with news that work on an anti-fragmentation tool will be accelerated with an announcement now expected at the July meeting.  Widening Italian bond spreads had been seen as a likely consequence of rate hikes, causing some to question whether they would be able to hike enough to counter the inflation threat. 

There are many unknowns with regards to the specifics of the programme, but headlines have been at the high end of expectations, with a light set of conditions expected, and triggers are likely to be based on quantitative benchmarks such as historic spreads. 

Overall, if the ECB is able to convince the markets that they can stamp out spread widening, hiking in greater increments becomes more straightforward.

 

Volatility: get used to it

If we take recent months in the round, forward guidance has been one of the most significant casualties. Previously, central bankers were able to anchor investor expectations by outlining a future policy path with clear signposts.

However, the Fed abandoned its guidance for a 50bps hike just hours before its policy meeting. And this is just the latest example of such an about turn – it was only in November that Christine Lagarde declared that the ECB was very unlikely to raise rates in 2022.

Going forward, investors may pay less attention to what central bankers say and react more to economic data. Overall, in our view this could increase market volatility and make it even more challenging for central bankers to meet their objectives.

 

Bank of England: not done yet?

Meanwhile, the Bank of England stood out as the only major central bank to deliver what had been previously anticipated.

However, sterling markets paid more attention to the messaging from the Bank that it ‘will, if necessary, act forcefully in response’[2] to the inflation threat.

Prior to this week, the prospects for the British economy appeared gloomy, with the global energy shock compounded by new trade barriers resulting from the UK’s departure from EU.

The Bank is therefore faced with an invidious trade-off, with growth faltering in recent months and a hot summer of industrial action increasingly likely.

Indeed, our analysis suggests they will need to continue driving rates higher to both stabilise the exchange rate and prevent the wage-price spiral from becoming entrenched - adding to the generally gloomy mood that has descended on global markets.

 

 

[1] Bloomberg as at 17 June 2022.

[2] https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2022/june-2022.