While rising inflation has led central banks to step on the rate hike accelerator, a shift may be on the horizon as inflation fears could soon give way to growth concerns, potentially driving central banks to tap the brakes.
June 29, 2022
Thomas Garretson, CFA
Senior Portfolio StrategistFixed Income StrategiesPortfolio Advisory Group – U.S.
Expectations that inflation would peak during the first half of the year now see that point materializing in the fall. The anticipated high-water mark has been pushed back given few signs that broad-based price pressures are easing, even as central banks are in the early stages of their rate hike campaigns. As a result, markets continue to price faster rate hikes, ultimately reaching a higher level, from most major global central banks than seen at any point yet this year.
Column chart showing how yearend 2022 central bank policy rate expectations have shifted sharply higher since the start of the year. U.S. rates now seen ending the year at 3.6%, Canada at 3.5%, the UK at 3.1%, and in Europe at 1.2% when initially in December 2021 rates were forecasted as follows: U.S. at 0.8%, Canada at 1.5%, the UK at 0.6% and Europe at -0.4%.
Source – RBC Wealth Management, Bloomberg; calculations based on overnight index swaps, data as of 6/21/22
The Federal Reserve stepped up its tightening effort with a 75 basis point (bps) rate hike at its June meeting that took the fed funds rate to a target range of 1.50 percent to 1.75 percent. The latest move followed hikes of 25 bps in March and 50 bps in May, and marked the largest incremental rate hike since 1994. Signs appear to point to at least one more such move when policymakers meet at the end of July – before the pace is likely dialed back to either 25 or 50 bps hikes at subsequent meetings.
Not to be outdone, after delivering a fifth 25 bps rate hike in June, the Bank of England (BoE) looks poised to pick up the pace as well. Markets are expecting a 50 bps hike at the next meeting in early August, which would bring the policy rate to 1.75 percent.
The Bank of Canada (BoC) has been leading the charge with three 50 bps hikes this year as policymakers have chosen to err on the side of predictability, but you guessed it, it is also now likely to kick things up a gear with a 75 bps move this month to a policy rate of 2.25 percent based on current market expectations.
But while rising inflation has led central banks to accelerate tightening, a shift could soon be on the horizon.
While the first half of the year was defined by a market increasingly focused on ever-higher inflation, the back half could see a shift to a market more concerned about ever-lower economic growth projections as tighter monetary policy takes a bite out of economic activity.
As the second chart shows, the divergence between consensus growth and inflation expectations has only grown larger over the course of the year as U.S. inflation forecasts for the year have climbed by 3.1 percentage points thus far to a 7.5 percent y/y rate. At the same time, GDP estimates have declined by 1.3 percentage points, with real economic growth, adjusted for inflation, now seen at 2.6 percent for the year. The same dynamic has played out, and to an even greater extent, in Europe. Inflation forecasts are up by 4.6 percentage points to 7.0 percent for the year, while real growth has faded by 1.6 percentage points to 2.6 percent for the year.
Line chart showing the net change in inflation and GDP growth forecasts for the period from December 2021 through June 2022 based on analysts surveyed by Bloomberg. Europe has seen sharp upward revisions to inflation with notable downgrades to growth. The same dynamic has been seen in the U.S., but to a slightly lesser degree. Current readings are: Europe inflation 4.55%; U.S. inflation 3.1%; U.S. GDP -1.3%; and Europe GDP -1.6%.
Source – RBC Wealth Management, Bloomberg Analyst Consensus Surveys through 6/21/22
To be sure, both growth forecasts remain strong and above long-term trends, but the divergence between higher inflation and slower growth is also showing up in consensus forecasts for 2023.
And that could be the catalyst for an eventual shift not only in market expectations, but also in central bank sentiment.
Those central banks that have been the first out of the gate in raising rates, the BoE, the BoC, and the Fed, are now seen by markets as likely to cut rates at some point in 2023. The European Central Bank has yet to raise rates, but it is likely to bring the negative rate era to an end by September, and should remain in rate hike mode through next year.
It remains to be seen whether market expectations for modest rate cuts next year are because of rising recession risks or because of cooling inflationary pressures. But the latter remains the ultimate goal of central banks: to snuff out inflationary pressures as quickly as possible, but to not go so far as to choke off economic growth as a result.
But will it work? Well, history isn’t exactly on the side of central banks, as the majority of tightening cycles have culminated in economic downturns of varying severity. In the U.S., the Fed is relying on a historically strong labor market and solid consumer balance sheets to buy policymakers some time for the supply side of the economy to recover and to offset weakness in the housing sector as mortgage rates rising beyond six percent have already significantly slowed housing starts and new home sales.
In our view, the Fed will end the rate hike cycle in December at a level around 3.25 percent before pausing to assess the economic landscape in early 2023. If inflation has shown “clear and convincing” signs of slowing by then, the Fed could deliver a few “insurance” cuts that would take policy rates back to the two percent to three percent “neutral” range – the level at which rates neither boost nor restrict economic growth – a range that Fed Chair Jerome Powell has cited in recent months. Such a scenario is now our base case as we think the Fed’s efforts to this point in terms of forward guidance, rate hikes, and the subsequent tightening of financial conditions will ultimately do more to ease inflationary pressures and excess demand than is broadly appreciated by markets over the next 6–12 months.
The key takeaway for investors is that faster and more aggressive rate hike campaigns in upcoming months should mean that peak rate levels prove to be lower than otherwise might be the case, and that rate hike cycles prove shorter.
While global sovereign yields have risen sharply through the first half of the year, with the benchmark U.S. 10-year Treasury yield higher by 194 bps to 3.28 percent, and the German 10-year Bund yield up by 179 bps to 1.76 percent, we think it will be a different story in the second half. We believe short-term rates will continue to rise as central banks remain on the rate hike path, but yields at the longer end of sovereign yield curves could find a top sooner rather than later, and begin to fade into year-end – particularly if recession fears continue to grow.
After a historically poor start to the year for fixed income markets, we believe the downside protection and ballast provided by bonds could attract investors back to the asset class, helping to reverse first-half losses.
And as a result, yield curve inversions – historically a leading indicator of recession risks – could become the focus point for markets and the basis for a new prevailing narrative in a number of regions later this year, serving as a key indicator for investors in gauging whether central banks are at risk of tightening beyond the point of snuffing out inflation, and to the point of snuffing out economic expansions.
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