Central banks continue to tighten, and fireworks not over yet

US Federal Reserve

The Federal Reserve (Fed) raised rates by 25 basis points (bps) on Wednesday taking the target rate to 5.25%-5.50%. This move was widely expected by the market and the Fed have done a great job over the last 18 months of delivering.

However, moving forward this may more be challenging. The Fed are now at a juncture where headline inflation and Personal Consumption Expenditure (PCE) data is tracking at 3.00% and the real target rate (target rate less Consumer Price Index) sits in positive territory. Chairman Jerome Powell stated that this would start to put downward pressure on inflation and economic activity, but the lags could be long and variable. He went on to re-iterate that inflation remains too high, but the committee have covered a lot of ground and future decisions will be purely data dependant. Consumer confidence and the labour market remains tight, which has led the Fed to believe that the risks of a recession have greatly reduced… the fabled soft landing!

So, what does all this mean for markets going forward? The number one likelihood is an increase in volatility around interest rate decisions and economic data. The next meeting is in late September and the market has a very low probability priced for any change in rates. However, any downside surprises to economic data in the meantime will likely see the treasury market pricing in more interest rate cuts in the future. The first rate cut by the Fed is pencilled in for May 2024 and a further four rate cuts to follow through to 2024. The initial market reaction post the rate hike was to steepen the yield curve with two-year yields falling 10bps and 30-year yields unchanged. Our view is that as the data continues to slow and inflation drifts lower over the course of this year we would expect to see the US yield curve steepen aggressively. Despite us being close to the end of interest rate moves for now I don’t think the fireworks are over yet for bonds!

European Central Bank

A day after the Fed, the European Central Bank (ECB) went into its July Monetary Policy Meeting with the market fully anticipating, and pricing, a hike of 25 bps, its ninth consecutive hike over the past 12 months. The reason the market had such certainty about this move was the comments made by ECB President Christine Lagarde in the June meeting that they would raise rates by a further 25bps in July, “barring any material change” to their baseline. Given the data over the period between these two meetings did not contain any material shocks, the ECB duly delivered its hike. However, this was not the main talking point from the July meeting; a change in the wording accompanying the rate decision gave a much stronger message that the rate decisions going forward are going to be far more finely balanced, stating that they will make “future decisions to ensure rates sufficiently restrictive”, having previously said that rates would be “brought to” sufficiently restrictive levels.

So, does this mean that the hiking cycle in Europe is over? Not necessarily. Inflation has declined but, “is still expected to remain too high for too long” and in her press conference, Lagarde was at pains to once again stress the ECB’s commitment to returning inflation to the 2.00% target over the medium term. Lagarde cited the good progress made to date and that the effects of moving to a more restrictive monetary policy regime are beginning to have the desired effect, but the job has not yet been done and they remain “determined to break the back of inflation”. What the meeting signalled was a clear shift to fully follow a data-dependent approach, with future policy decisions not being made ahead of an “assessment of the inflation outlook in the light of incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission”. In the press conference, amongst other things, Lagarde was pushed to give details of what specific data items the ECB would be looking at, and at what levels would these need to be in order to determine their interest rate decision. Unsurprisingly, she was unwilling to give specific answers on this, but was explicit in the full reliance on the data dependence and that decisions over the next several meetings will be whether to hike further or pause and would not involve a rate cut. Additionally, and consistent with the data dependence approach, were a decision to be made not to hike in September, then this would not necessarily mean the hiking cycle is over – it all depends on the data!

In terms of the market reaction, the initial interpretation was somewhat dovish, with European government bond yields falling and curves steepening, perhaps indicating that the market feels that once the ECB pauses, (which may be as soon as September), it would struggle to raise rates again, particularly in an environment where the Fed may have reached the peak in rates for this cycle. One thing we can say though is that with such an explicit commitment to data dependency, every significant data release between now and September will be highly scrutinised as markets try to determine its importance to the ECB’s decision-making process. Notwithstanding the summer period, which is typically characterised by lower volumes and fewer market participants, we could still see even larger responses by the market to data releases than has been the case historically. Time to buckle up for what could be a very volatile few weeks!

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