For financial professionals only
Whilst the atrocities of human suffering inflicted by Russia on Ukraine continue, central banks in the US, UK and EU have been considering how to deal with rising inflation despite a slowing growth outlook.
Given the heightened macroeconomic uncertainty the European Central Bank (ECB) left interest rates unchanged, albeit pointing towards a faster wind down of its asset purchase program. By contrast the Fed and Bank of England (BoE) both raised interest rates by 0.25% at the March committee meetings. The former expressing a clear desire to be seen focusing on controlling inflation to better manage inflation expectations.
However, much of the current inflationary spike is supply side driven, which raising interest rates will not assist with. The Fed’s message of being serious about inflation is prudent and pragmatic, but the board’s projected future rate hikes seen in the latest ‘dot plots’ have reaffirmed concerns amongst some investors of a looming policy error. As the chart below shows, the Fed anticipate a further six 0.25% interest rate hikes by the end of 2022, with another 4 in 2023.
Source: Bloomberg
At a time when economic momentum is already slowing and high frequency data pointing to weakness, it’s unsurprising that the yield curve shape continues to flatten, as confidence in longer term growth deteriorates.
Flattening US yield curve:
Source: Bloomberg & Schwab
History shows that when the 2yr/10yr yield curve inverts, i.e. yields on long dated bonds are lower than short dated bonds, a recession typically follows within the next 12-18 months.
Clearly the Fed is aware of this, so it’s assumed they’re attempting to find the illusive balance of moderate inflation with steady growth. Pulling it off would be quite an achievement, especially since virtually all previous rate hiking cycles have ended the prevailing business cycle. Compounding the concern is financial conditions in the US and EU having already notably tightened (as seen in the chart below), and that was even before the Fed raised interest rates.
Tightening financial conditions in the US and Europe:
Source: Bloomberg and Charles Schwab
However, as seen in the chart below, the market is already discounting a further 6 rate hikes in 2022. This is in line with the Fed’s updated dot plots, so much of the concern already appears to be priced in. And both the Fed and BoE have also emphasised the need to be nimble and flexible with monetary policy given the macroeconomic uncertainty ahead.
Markets expect the federal funds rate to peak in mid 2023:
Source: Bloomberg and Charles Schwab
So having been labelled as being ‘behind the curve’ on inflation, the Fed and BoE are now attempting to ‘catch up’. How aggressive they are in pursuing this ‘catch up’ will determine whether or not there’s a hard or soft landing. History suggests investors need to keep an eye on this, but for now there’s no need to panic. Looking at China, the second largest economy in the world, monetary and fiscal policies are actually becoming more accommodative and supportive of growth. This suggests room for upside surprise, which may help to offset part of the slow down anticipated in some western markets.
Chinese credit impulse and business cycle:
Source: Alpinemacro.com
China fiscal expenditure as % GDP:
Source: Alpinemacro.com
As a result, we remain firm advocates of long-term investing and reiterate the importance of maintaining a diversified portfolio to ride through the many uncertainties that appear to lie ahead.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.