With no sign of respite from inflationary pressures, central banks are embarking on a significant tightening of monetary policy. Valuations of risk assets have fallen sharply as investors adjust to the abrupt change in the policy stance at the US Federal Reserve and European Central Bank. Sentiment regarding economic growth is poor with stagflation a key worry.
A turning point
For the global economy and financial markets, the week ending 17 June marked a definitive turning point. As central banks made it clear that meaningful policy action was required to rein in inflation, there was a realisation that a transition to a new and more challenging regime for financial conditions is underway. The decision by the US Federal Reserve to hike its benchmark interest rates by 0.75% on 15 June went against its own forward guidance of a 0.50% rise. It constitutes a measure that Chair Jay Powell had ruled out only a few weeks earlier. It is now clear that after a long period of hesitation the US Federal Reserve has recognised that it has to address inflation more forcefully, come what may.
Our macro-economic team expect the Federal Reserve will now tighten monetary policy quickly with another 75bp increase in July, followed by 50bp in September and November, then 25bp in December and January with policy rates finishing the cycle at 3.75-4%. Our fixed income team projects US Treasury 10-year yields at 3.50% by year-end (versus 3.17% today) before falling modestly in first quarter 2023 to around 3.25% as growth and inflation slow.
Chair Powell echoed June’s Federal Open Markets Committee (FOMC) message at the semi-annual congressional testimony on 22 June. Given the consistency and tone of his remarks it appears the Chair feels no need to correct current messaging.
Central banks running to catch up
In the week ending 17 June 2022, the Bank of England implemented a fifth consecutive hike to interest rates as it seeks to rein in soaring inflation. The Monetary Policy Committee voted 6-3 to increase the Bank Rate by 25 basis points to 1.25%, with the three dissenting members voting for a 50 bp hike to 1.5%. The committee said in a statement on 16 June that it will “take the actions necessary to return inflation to the 2% target sustainably in the medium term,” with the scale, pace and timing of any further hikes depending on the economic outlook and inflationary pressures.
Also on 16 June, in Switzerland, policy rates were raised for the first time since 2007. The Swiss National Bank raised its policy interest rate on 16 June to -0.25% from the -0.75% level it has deployed since 2015. Inflation in Switzerland is running at around 3% and the SNB sees increasing risks of second round effects.
These rate hikes follow in the wake of policy tightening by The Reserve Bank of Australia (RBA), which announced on 6 June its biggest single rise in the cash rate in 22 years as it sought to contain inflationary pressures. The RBA board lifted its cash rate target 50 basis points to 0.85%. “Inflation in Australia has increased significantly,” said the RBA governor, Philip Lowe, in a statement. “While inflation is lower than in most other advanced economies, it is higher than earlier expected.”
In the first week of June Canada’s central bank last week lifted its cash rate by 50 basis points for second month in a row and in May New Zealand hiked its main policy rate by 0.50% to 2%.
In almost every major economy policymakers have been caught flat footed by a rise in inflation that many initially dismissed as transitory. The emphasis now at most central banks is reducing policy stimulus and tightening monetary policy.
Stock markets fall
Markets appear to have drawn the conclusion that with the risk of fed funds at 4% by end 2022 and faster tightening by the above-mentioned central banks, recession probabilities are increasing. As a result, in the week ending 17 June, global stocks suffered one of their worst weeks since the outbreak of the coronavirus pandemic. As of 22 June, the S&P 500 stock index is down by 21.11%
Investors were, not surprisingly, caught off-guard by the 75bps rate hike from the Fed. This not only resulted in a sharp rise in the real yield (a key proxy for the discount rate) but also increased worries the Fed will ultimately trigger a recession. Uncertainty around the outlook of inflation and fears of monetary policy triggering a recession will likely continue to be major sources of volatility for equity markets. That being said, the recent speed and breadth of the sell-off suggests we might be getting closer to full investor capitulation.
US inflation expectations
Long-term inflation expectations are likely to remain firm in the final June University of Michigan print, due for publication on 24 June. The preliminary June University of Michigan report, which showed 5-10-year inflation expectations jumping to 3.3%, was, in our view, a key factor leading the Fed to breach its prior forward guidance and deliver a 75bp hike at the June FOMC. The Fed will be highly attuned to any further movement, beginning with the potential for revisions in the survey’s final June release. There would appear to be little scope for a downward revision to the June print, especially with gasoline and food prices continuing to climb.
Outflows in credit markets
Concerns of a central bank policy induced recession led to record outflows of US high yield as investors worry about rising default risk. The week ending 17 June saw a USD 6.6bn withdrawal from US high yield bond funds, making it the worst week for outflows since the sell-off in March 2020. For the year-to-date, according to EPRF, high yield outflows total nearly USD 35bn. US investment grade corporate debt also experienced USD 2.1.bn of outflows in the week through 17 June.
Too early to buy risk assets
Our multi asset team consider that from the perspective of the equity risk premium relative to the credit spread, investment grade credit appears attractively valued in both the US and Europe (though this is not the case in high yield). They think it is too early to dip into risk assets, but credit is a clear candidate for adding risk should our appetite increase.