Central Bank hiking cycle - “They think it’s all over….”
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Article Type
BondTalk
Topic
Banks
Published
November 09, 2023
Read time
4 mins
Author
Colin Finlayson, CFA
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For the last two years, Central Banks have been continually hiking rates, waging war against inflation which had reached near 40-year highs. The unprecedented pace and magnitude of the monetary tightening has seen rates increase by 5.25% in the US, 5.15% in the UK and 4.50% in Europe, upturning financial markets in the process. The question asked by all investors was "when will they stop?".

 

Over a recent seven day period, we saw the ECB, the Fed and then the Bank of England all choosing to keep rates on hold at the same time for the first time since the cycle began. This has brought a growing belief that we may now have reached the peak in the hiking cycle. To paraphrase that famous football quote: "They think its all over..." and there is reason to believe that it is now.

 

At each of the Central Bank meetings, the tone was more balanced with regards to upside and downside risks. While no Central Bank wants to claim victory over the inflation bogeyman - instead ensuring that they keep a tightening bias in place - all have acknowledged that policy is now in restrictive territory, even before the lagged impact of prior rate hikes has been felt.

 

Official Key Rates of Fed, ECB and BoE

 

Official Key Rates of Fed, ECB and BoE

 

Although headline inflation in the UK is the highest of the three regions at 6.7% year-on-year, powerful base-effects will move this sharply lower in the coming months, with the Bank of England forecasting something close to 4% by year end, falling to 3% then 2% by subsequent year-ends. Aside from the inflation story, the impact of higher rates is already being felt, with growth slowing to a near standstill and business and consumer confidence taking a hit. The economys sensitivity to mortgage rates also favours a more careful approach from here.

 

The situation in Europe is mirroring that in the UK but with an already lower inflation profile - the latest European CPI report showed inflation had eased back to 2.9%, with year-on-year prices in the Netherlands actually in negative territory at -0.4%! With the German economy having now contracted in two of the last three quarters, its difficult to argue that higher interest rates are still needed.

 

Headline CPI - US, UK, Europe

 

Headline CPI - US, UK, Europe

 

The story in the US has been less straightforward: they were the first to see inflation peak (before then falling back to the current level of 3.7%) and the Fed has been hold at 5.50% since the summer. The recent soft landing narrative and ongoing firmness in the labour market has, however, kept further hikes on the table. The tone of the latest Fed meeting felt less hawkish - referencing the headwinds from higher market interest rates (bond yields), and their belief that the full extent of prior tightening is still to be seen. It feels that the bar for further hikes is getting higher. With two key pieces of macro data - Manufacturing ISM and Non-Farm Payrolls - both surprising to the downside in the past few days, the likelihood of the Fed being on-hold has only gone up.

 

What does this mean for the bond market? In short, a lot. The relentless rate hikes have been the driving force in pushing bond prices lower - with no confidence on when the rate hikes would end, fixed income buyers have chosen to sit on their hands. Maybe thats about to change. When looking at the path of future interest rates, there are three possible outcomes: higher, lower, or unchanged. If the option of higher rates is taken off the table - leaving unchanged or lower interest rates - the risk/reward profile for bond investors improves as a result. With the threat of higher rates now much reduced, the longer-term potential for fixed income markets can start to be realised.

 

After hundreds of basis points of rate hikes, and meaningful progress being made on the fight against inflation, the recent hat-trick of holds from the ECB, Fed and Bank of England may well signal the end of the hiking cycle. While they will be shy in claiming victory in this campaign, time will tell if this proves to be the point where their goals were met.

Important disclosures

Author

Colin Finlayson, CFA
Portfolio Manager

Colin Finlayson, portfolio manager, is a member of the global rates and multi-sector portfolio management teams.

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