Two years ago our focus was on the “three P’s”, now it is on the “two P’s”. Then it was about inflation, now we are referring to interest rates. In 2021, we were worried about inflation – then the question was whether rising inflation would pass-through, persist or be permanent.
We felt central banks were wrong to believe it would be temporary, and pass-through quickly, and their policy then was making the outcome worse. We didn’t think the rise would become permanent, but we certainly felt it would persist, as it has. Now, inflation has peaked and is decelerating, but it is unclear where it will settle.
In the UK the immediate outlook will be impacted by second-round effects. This includes higher wages, although I do not think higher public sector wages threaten the inflation outlook. Also, how firms respond to higher costs will be key – and whether and by how much they raise prices to maintain or boost margins.
And, of course, there is monetary policy, which leads on to the issue of the two P’s that we need to focus on now: peak or plateau? Will policy rates peak or plateau this year?
Markets expect significant inflation deceleration
There has been considerable monetary policy tightening in western economies, led by the US and the UK, and this has included rate hikes, quantitative tightening and guidance. This approach has been effective and along with an easing of supply-side pressures as economies have reopened and a reduction in energy prices, the net effect is that inflation has peaked. Markets are discounting a significant deceleration.
Monetary policy works with a long and variable lag. Yet all too often the policy debate is about current economic indicators. The policy response appears more coincident, based on current data, as opposed to forward-looking. This contributed to problems a couple of years ago, with central banks easing when they should have been tightening. The fear now is that this approach leads monetary policy to tighten too far, thereby triggering a sharp economic slowdown that otherwise might be avoided.
In recent weeks there has been less pessimism about the world economy, with notable pointers being strong jobs data in the US and the reopening of China. This optimism was also evident with the International Monetary Fund (IMF) revising up its forecasts for global growth. Last year, in contrast, the IMF cut their global growth forecasts three times.
Admittedly, it is still a weak picture, with global growth expected to be 3.4% last year, 2.9% this and 3.1% next. Anything around 3% is weak, although as inflation decelerates this may help boost spending and confidence more than expected.
Central banks still have a bias to tighten
This economic backdrop has helped equity market confidence in recent weeks, but the message from bond and money markets is pretty clear: as inflation decelerates there will be little need for much further monetary policy tightening; while the risk of slowdown next year will lead central banks in the west, led by the US Federal Reserve (the Fed), to cut policy rates.
The market expects policy rates in the US and UK, for example, to be higher in a year’s time than they are now, but to have peaked this July before then falling. The market expects the UK policy rate to rise from 4% now to a peak slightly above 5% this July, before being reduced to 4.75% by early next year.
This idea that rates will peak can be interpreted in two ways. One, that the markets still believe that monetary policy will be fine-tuned, in response to current economic conditions, thus, effectively acting as a shock absorber. Two, that policy may become too tight, meriting easing. There is little doubt that central banks still have a bias to tighten, based on their recent actions and comments.
Recent market moves reflect this. The Chinese equity market, for instance, has become more expensive in the wake of its reopening. Also, the expectation that the Fed will peak has seen the dollar weaken, while hawkish comments by the European Central Bank has led traders to build up large speculative positions in the euro.
Meanwhile, consistent with the expectation that policy rates will fall, yield curves in the US and UK have been more inverted this year with longer-term yields falling by more than shorter-dated ones. This is not only consistent with the market expecting inflation and policy rates to fall, but also with growth weakening, too.
Since the start of the year, for instance, UK 10-year yields have fallen by 0.27% more than 2-year yields, while in the US this inversion has been slightly greater with 10-year yields declining by 0.3% more than the 2-year Treasury Rate.
A case for rates plateauing?
But is it right to expect policy rates to peak and then fall? It is certainly possible. After all, we know that central banks believe that the equilibrium for policy rates is still low. We know this from their previous discussions about “r-star” which is the equilibrium for policy rates after allowing for inflation. So if inflation settles at a 2% target and r-star is 0.5% then policy rates should settle at 2.5%. Before the pandemic policy markets thought r-star was close to zero in western economies.
But might there be a case for rates plateauing, not peaking? And indeed, might there be a case for that plateau to be where we are now?
Take the UK: inflation has peaked, the economy has slowed, previous rate hikes have still to feed through and further monetary policy tightening is in the pipeline with a reversal of quantitative easing. Already, quantitative tightening has seen the Bank of England nearly half way through selling its £20 billion holding of corporate bonds, and its auctions of gilts suggests it is now holding around £827 billion of gilts, versus £875 billion at the peak.
Additionally, not through auctions, but through an open-book approach, it has sold the £19.3 billion of gilts it bought to stabilise the market from the LDI crisis last autumn. This is a lot of supply that the markets have had to absorb, alongside normal issuance to fund the large budget deficit.
Rates plateauing would also allow the Bank to assess its future approach, when the inflation and growth outlook is clearer. There is a strong case to avoid cutting rates which is what would happen after a lag if rates were to peak. That is for fear of resurrecting the problems associated with cheap money since 2008 – namely asset price inflation, markets not pricing properly for risk, a misallocation of capital and an environment in which inflation soared.
In our view, policy rates should plateau now in the UK and US for the reasons cited above. However, in all likelihood, given recent signalling by the central banks, the market is right to price in further tightening.
Please note, the value of your investments can go down as well as up.