Financial update from Brewin Dolphin - 17 June 2022
Friday 17 June 2022
In her latest weekly round-up, Janet Mui, our Head of Market Analysis, analyses this week’s slew of central bank policy meetings and the potential impact of interest rate hikes.
This week was all about central bank action, with the US Federal Reserve, Bank of England (BoE) and Swiss National Bank announcing interest rate hikes, while the European Central Bank (ECB) called for an emergency meeting.
Higher interest rates through the rest of 2022 are now a certainty. Markets will have to live with this, but traders have been swift to price in jumbo and rapid rate increases. The focus is turning more and more to the risk of a recession given much tighter monetary policy.
First, let’s recap the Federal Reserve’s policy decision. The bank raised rates by 75 basis points (bps), which brings us to 1.75% on the Fed funds target rate. It is also now reducing the size of its balance sheet. This shows the Fed is desperate to restore its inflation-fighting credibility, after keeping policy too loose for too long. In the Fed’s mind, the risk of unanchored inflation expectations (such as the wage-price spiral of the 1970s) dwarfs the pain of falling stock prices and a potential recession. The Federal Reserve now sees interest rates at 3.4% by the end of 2022 (meaning at least half-point hikes at all the remaining four policy meetings this year) and 3.8% by end of 2023.
The Fed also released its quarterly summary of economic projections. It revised up its expectations for inflation, the path of the funds rate and unemployment, and downgraded its projections for economic growth. Interestingly, the Fed expects aggressive rate hikes to have only a modest negative impact on the unemployment rate (its economic projections now show the unemployment rate rising to 3.9% in 2023 and 4.1% in 2024). So, the Fed thinks a soft landing remains the base case. This will be a key point of debate for markets; for now, they are unconvinced about the Fed’s ability to engineer that soft landing.
Despite the relief-rally on the day of the Fed’s meeting, US equities slumped the following day and are on track for their biggest weekly loss since the worst of the pandemic. With the markets so sensitive to the risk of a recession, a series of poor US economic data has been unhelpful. This week, we had a couple of weak US housing market data including homebuilder confidence, housing starts and building permits. With the US 30-year mortgage rate reaching almost 6% and seeing the biggest weekly jump since 1987, it is most likely going to dampen confidence and pose big headwinds to housing affordability for upcoming homebuyers. Weaker housing construction will feed directly into gross domestic product and related discretionary spending will also be affected.
Bank of England
Turning to the UK, the Bank of England hiked interest rates by 25bps on Thursday, bringing the base rate to 1.25% as expected. The BoE has signalled that, if needed, it could enact bigger rate hikes to tame inflation. Its commitment can hopefully help to prevent high inflation expectations from becoming entrenched.
Although the BoE now sees UK inflation rising to 11% later this year, a 25bps rate hike pales in comparison to the jumbo rate hikes of the Fed. The BoE is probably more concerned about the recent softening in data, with it now forecasting a -0.3% contraction in GDP in the second quarter. There are other specific UK challenges, and the labour market is also not as tight as it is in the US. Markets are now pricing in an interest rate of 3% by the end of 2022, which looks pretty steep compared to the BoE’s stance so far.
The immediate impact of this hike to the real economy is still limited, but it will certainly add incremental financial pain to people with floating-rate mortgages or who are getting close to the time for refinancing. Over 80% of mortgages by value have an interest rate that is fixed for an initial period, so their repayments will not be affected for now. That said, quoted rates on mortgages have increased across the board and are likely to continue moving higher, so when homeowners come to refinance some will find the terms to be less advantageous. Overall, the tightening financial conditions should slow demand and curb inflation with a lag. Interest rates on instant-access deposits have also increased, though by much less than for quoted mortgage rates. So, savers are not getting many sweeteners while borrowers are seeing more pass-through of higher interest rates.
Despite a smaller rate hike than it could have been, there was a huge reaction in the bond market, with the two-year gilt yield finishing the day 19 bps higher. Gilt investors seemed focused on a pledge from the BoE that it is ready to act forcefully in response to persistent signs of inflationary pressure. This forward guidance was approved by all nine members of the Monetary Policy Committee, unlike in May when two members declined to endorse the more hawkish forward guidance.
Traders now believe the BoE will hike rates to 3.4% by next May. That’s only 40 bps below the expected peak in the Fed funds rate. Interest rate differentials are an important variable in determining the pound’s direction, so the narrowing in interest rate spreads between the UK and the US yesterday helped to spark a rally in sterling. The move was probably amplified by the fact that speculators were negatively positioned on the pound heading into the meeting.
European Central Bank
The ECB called an emergency meeting on Wednesday, focusing on the so-called fragmentation occurring around the eurozone as expectations for ECB policy tightening pick up. Spreads among the weaker countries in the eurozone have all widened versus their more fiscally stable counterparts. But the country that is of most concern is Italy, with the ten-year yield surging to a high of 4% recently. This puts the ECB in a difficult position. The economy is running out of spare capacity, inflation is already high, and inflation expectations are rising.
Against the backdrop of a deposit rate that is currently -0.5%, the ECB must raise rates or risk severely damaging its credibility. But that risks bringing pain to Italy. Euroscepticism in Italy is nowhere near as bad as it used to be, but there is the potential for that to change on the back of economic pain. This would bring back existential risks, which the ECB wants to avoid.
To allow it to raise rates and at the same time address this fragmentation, the ECB pledged to apply flexibility in reinvesting redemptions of its Pandemic Emergency Purchase Programme. In plain English, this means that as the bonds it holds mature, it may look to skew what it chooses to buy with the proceeds toward areas of the periphery like Italy. The ECB had already pledged to do this; the new announcement from the meeting was a promise to quickly design a new tool to address fragmentation but, so far, no details have been released. ECB president Christine Lagarde said the mechanism could involve intervening if peripheral bond spreads become too wide, but she didn’t mention if there would be a target spread. Governing council member Isabel Schnabel laid out a path on Tuesday, and referenced the Outright Monetary Transactions tool that was unveiled following Mario Draghi’s “whatever it takes” speech as an example of the ECB’s ability to respond to these challenges.
Bank of Japan
In contrast to other major central banks, the Bank of Japan is currently sticking with ultra-dovish policy. On Friday, it reconfirmed a commitment to continuing daily bond purchases and making no changes to its yield curve control policy. This means the ten-year Japanese government bond yield stays within a narrow band of around 0%.
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