Dot plots and dovish hikes to create divergence

All change once again

There has been a good deal of commentary that the Russian economy (GDP = $1.5 trillion, before they invaded the Ukraine according to the IMF) being only slightly smaller than that of Italy ($1.9 trillion) but larger than that of Spain’s ($1.3 trillion). The implication being that the Russian economy is not of sufficient size to really be of long lasting concern to the rest of the world. However, that doesn’t take into account how Russia dominates a few narrow but critical supply categories, most notably in energy (12 percent of global oil and 40 percent of gas to Europe). Breaking that market down, Russia produces both significant amounts of oil (for which there are a host of alternative global suppliers), and gas (a more regional market where finding alternative supplies is far more difficult). In practice this means energy price rises across Europe are likely to be far more lasting than anticipated, with electricity prices in particular, likely to remain higher, for longer than petrol prices.

Are interest rates going to break the housing markets?

The higher levels of inflation resulting from these increases to the cost of energy, clearly require a response from central banks. Already the Bank of England, as well as the US Federal Reserve, are tightening monetary policy. If one simply looks at the path financial market investors expect interest rates to follow, you might conclude that rates were headed north of two percent within the next year. This would put interest rates close to, what is assumed by academics, would be their “neutral” level; sufficiently high to counter inflation, but not so low as to encourage asset bubbles or mal-investment. While such a move would meet central banks’ mandate to counter inflation, there could be a disproportionately hefty cost to pay as well. Our view is that the prolonged period of extraordinarily low interest rates, which has dominated monetary policy around the developed world since the Global Financial Crisis of 2008, has resulted in inflated asset prices. Moving to what might be considered more historically “normal” valuations, while desirable, has to be done carefully. A rapid asset price correction would likely trigger a recession of the sort experienced in 2008-09, particularly if it is centred on people’s biggest asset, housing. Because central banks have a mandate to counter inflation, but not a carte blanche to pursue this at any cost, we do not think such a path to 2.5 percent is likely. As the boss of US bond fund PIMCO, Bill Gross, commented to the FT in March, a rapid move towards theoretical neutral levels of 2.5 percent, would crash the overall housing market. He was looking at the US, but the same could be said of the UK housing market. Asset prices have taken a good deal of time to rise to present valuations, the best we can hope for is that we take our time reversing the situation.

James Sproule, Chief Economist

A dovish hike from the Bank of England

Markets went into the March 17 meeting expecting the Bank of England to raise rates again by 0.25%, taking base rate to 0.75%. In the build-up, rates markets globally had been thrown into a tug of war by the Ukraine conflict. Traders weighed up greater inflationary pressure in the short term caused by higher commodity prices, against a potential disinflationary outcome, should the hit to household incomes filter through into a slower economy. 

Market volatility was testament to the intensity of this debate, with so much unknown about the extent of the crisis, and the response from governments to mitigate the hit to consumers. However, it soon became apparent that more weight was being placed on central banks continuing to press on with policy tightening plans as higher, possibly stickier inflation, cannot be ignored. Overnight Index Swap (OIS) markets reverted back to, and then exceeded, pre-war expectations for policy tightening in the UK and US.

Despite some caution, and allowing for flexibility, the European Central Bank (ECB) added fuel to the fire with its decision on March 10th to speed up asset purchase tapering this year, with a potential end date in Q3 this year. This accelerated market expectations for rate hikes to commence in the autumn, and now points to the deposit rate being in positive territory by the end of 2022. The Federal Reserve (which raised rates by 0.25%), was also rather hawkish in its tone at the March 16 meeting. We saw an update to the Fed’s interest rate forecasts, known as the dot-plot, which now sees the median Fed Funds rate at 1.9% at the end of 2022. This implies a rate hike in each of the remaining six meetings this year, matching exactly the market expectations prior to the meeting.

The implied rate path for 2023/24 was also increased, with the median Fed Funds hitting 2.75%, implying a policy rate higher than the so-called terminal rate.

With the above in mind, the market went into the Bank of England Monetary Policy Committee (MPC) meeting expecting at a minimum a 25 basis point hike, whilst also factoring a 20% chance of a 50bp hike. The MPC did raise base rate to 0.75%, but the decision has been labelled as a “dovish hike”. The decision statement struck a cautious tone in relation to the current economic climate, placing more weight on the impact of household incomes, and the subsequent impact on economic growth as a result of the war in Ukraine, which has sent commodity prices soaring. Indeed, the MPC voted 8-1 in favour of a 0.25% hike with the dissenter, Jon Cunliffe, voting to keep rates on hold at 0.5%. This is a dramatic change from a month ago where four members dissented in favour of a larger increase at the February meeting, highlighting how ‘shocks’ can change conditions and outlooks so quickly. Mr Cunliffe’s dissent took the market by surprise in particular.

I have mentioned before the importance of forward guidance/communication in central bank decisions, and in fact it holds greater importance to the market than the decisions themselves; even subtle changes in statement wording can have a big impact. In the MPC statement, it was noted that further modest tightening “may be appropriate”, rather than “is likely to be appropriate” – even just one word changes the whole tone of the message. Nevertheless the MPC still sees inflation as a threat, and in the statement noted that we are likely to see inflation at “around 8%” in the coming months, up from the February forecasts of 7.25%. The MPC therefore felt it was necessary to press on with rate hikes, to get ahead of inflation to ensure confidence and credibility in the central bank is maintained.

The reaction

The UK rates market reacted in typical fashion, lower across the curve. Swap rates with shorter maturities fell by 20bps+ as one 25bp rate hike was priced out of the curve. Longer-term rates fell by not as much, with five and ten year SONIA swaps falling around 10 and 8 basis points respectively. It’s amazing that in this day and age we do not see a move of this magnitude as noteworthy, evidence of the volatility in UK rates this year.

The move lower was quickly sapped and both shorter and longer-term rates retraced their post Bank of England decision steps; the market again sees base rate reaching at least 2% by year end. This view was emboldened by further hawkish comments from Fed Chair Jerome Powell, who mentioned the possibility of larger, 50 basis point hikes in the coming meetings (Two 50bp hikes are increasingly being priced in by the market for the next two meetings!) . This allowed OIS rates globally to adjust higher –  UK OIS rates are again attaching a 80% chance of a 50bp hike in the summer. Most economists still, including James Sproule and our UK economist Daniel Mahoney, only see 1-2 more 25bp hikes this year.

Perhaps the answer lies between the two, and we are likely to have a better picture by the summer, after another hike in May. However, I do see further divergence between US and UK rates playing out in due course. The OIS trajectory for both economies over the next 12 months still look similar. This does imply more hikes from the Fed as they are starting from a lower base, but even taking this into account, I still see some adjustment needed. Previously I have mentioned the relationship between both economies and that their policy cycle would likely move in tandem, hence why developments in US rates markets is mentioned frequently in this piece.  The outlook has been complicated by Russian sanctions due to relative exposure, mainly through commodity prices, that is likely to dampen the UK’s economic prospects far more than the US. 

The US is shielded from higher energy prices to a degree given it is a net producer of oil and gas, whilst that doesn’t mean the consumers won’t feel the squeeze from higher pump prices, the profits and investment in the oil and gas industry can create positive multiplier effects throughout the economy. The US has a lot more demand driven inflation, following various stimulus packages and large savings to draw on, which allows the Fed to be more bold and hawkish. So, overall, whilst we can never ignore the actions of the Fed, we are likely to see divergences open up between the Fed and Bank of England as time goes on. Perhaps the movements from the ECB become more relevant for UK given the geographical proximity?

Inflation Expectations

The Bank of England’s number one job, and the reason for the pre-emptive rate hikes is to keep inflation anchored toward its target. The central bank can’t control changes in commodity prices, but it can use monetary policy to keep expectations tempered. Market and consumer-based measures of expectations have risen with inflation over the past few months, moving higher in the wake of Russia’s invasion of Ukraine, but they are off their peaks.

With real disposable income falling this year, it would be expected that employees look for greater salary compensation to account for the increase in cost of living, but this is the avenue in which higher expectations become embedded – the so-called wage price spiral, or perhaps better termed in this environment as the price-wage spiral. This is a concern for the Bank of England and it creates a difficult environment to operate in. Governor Andrew Bailey knows this only too well, after the backlash he received following comments that employees should not ask for big wage rises. The Bank of England has had to be ruthless with raising rates quickly in this cycle, but the caution in the statement this month suggests that the central bank is wary about hiking its way into a recession.

The MPC should get a helping hand though later this year and next as commodity prices normalise from extreme levels, even though they may remain elevated compared to pre-invasion of Ukraine. Brent crude oil prices have already fallen from a peak of $139 a barrel to around $115 now, whilst UK natural gas prices for nearest delivery, trade at less than a third of its peak of near 800 pence a therm. More importantly, the futures curve for both oil and gas prices are trading in backwardation, meaning that prices are expected to fall over the next 12-18 months. This, along with fiscal support from the government, suggests that both the hit to consumer incomes, and inflation will ease in the not too distant future. From next year, through base effects, inflation should be allowed to fall from such elevated levels.

With more weight being placed on the hit to consumers and the knock-on effects for growth, the swap curve should steepen, as alluded to in February’s Rate Wrap. Rates for shorter maturities will fall greater than five year rates and beyond. The curve however will remain inverted for some while, at least until the summer when we will know for sure whether the Bank of England is finished raising rates.

Financial conditions

A close eye is being kept on signs of stress in the banking sector as a result of the sanctions on Russia. Some gauges in the US and Europe, such as the spread between short-term forward rate agreements and OIS rates (FRA/OIS), had widened to levels not seen since May 2020. Peak pandemic level stress in the banking sector remains some way off, and this type of contagion risk to the rest of the market seem minimal at the moment, even more so after Russia made a coupon payment on a dollar bond on March 16. However, as we know what happened to longer-term rates after the last credit/rates market blowout, markets will be watching closely.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg