Interest rate peak? Not yet

With market expectations on interest rates swinging with every data release, central bank meetings are under the microscope. This week saw the Federal Reserve (Fed) and European Central Bank (ECB) announce latest decisions, with the Bank of England meeting next week.

Federal Reserve

The Fed maintained its policy rate band between 5% – 5.25% at the June meeting, which was widely expected by the market. The ‘skip’ in policy rates as it has become known was really just the support act to the accompanying statement which was the main event. Would that statement be ‘Dovish’ or ‘Hawkish’?

Analysing the data revisions and the revised dot plots, it quickly became clear that this was a ‘hawkish hold’. The Fed officials pencilled in a further two interest rate hikes over the coming quarters as well as revising up their expectations for inflation, citing a strong labour market and persistent ‘stickier’ core inflation. However Fed Chairman Powell’s press conference was slightly more balanced, highlighting that a lot had already been done and that real interest rates were now moving into positive territory. This leads to tighter financial conditions which should in effect cool the economy in the second half of the year.

The initial market reaction saw a re-pricing of interest rate expectations, taking out any probability of cuts in the second half of 2023. The resultant move in the yield curve was to flatten sharply with longer dated assets outperforming shorter dates on a relative basis. However as the dust began to settle we have seen some stabilising of yields as markets perhaps begin to focus on the fact that central banks will not stop until the job of killing inflation is over…which greatly increases the likelihood of a recession.

European Central Bank

The ECB held its nerve and followed through on it expected hike of 25 basis points (0.25%) to all its main interest rates at its June meeting, despite the Fed electing to keep their rates on hold the day before. Moreover, during the press conference that followed, ECB President Christine Lagarde went as far as saying that, “barring a material change”, we can expect a further hike of 25bps in July. The reason for continued tightening in policy rates is clear; in the ECB’s own words, “Inflation has been coming down but is projected to remain too high for too long”. This meeting saw a fresh set of Euro-system staff inflation forecasts, in which inflation is projected to remain above the ECB’s 2% target in 2023, 2024 and 2025.

So the ECB remains resolute in its determination to achieve its goal of price stability through the continued tightening of monetary policy, whilst simultaneously assessing incoming economic and financial data underlying inflation dynamics to assess when conditions are adequately restrictive to achieve its target.

Initially, European government bond markets sold off in reaction to this, with weakness across all maturities. However, as the trading session following the ECB press conference went on, the market saw a recovery in longer dated bonds, with shorter dated tenors bearing the brunt of the ECB’s hawkish messaging. Volatility remains a dominant theme in European government bond markets and longer dated bonds seemingly unable to maintain yield levels seen elsewhere in global government bond markets.

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