Senior Fixed Income Strategist
Summary: The market is not buying the Federal Reserve nor the Bank of England's message. While the Federal Reserve is confident to tighten the economy aggressively in the US without causing a recession, the bond market says that a downturn might be inevitable. Despite a dovish monetary policy meeting in the UK, investors remain of the idea that the BOE will not be able to afford its dovish stance and that it will need to hike rates to 2% by the end of the year.
Following a hawkish European Central Bank last week and Federal Reserve yesterday, the market expected the Bank of England to follow through with a hawkish monetary policy decision today. However, the BOE didn’t join the chorus of central banks saying that inflation needs to be fought and redirected its focus towards growth instead of price pressures. That is a massive change from the BOE's February meeting, in which four out of nine members voted in favor to hike rates by 50bps instead of 25bps. As one can deduce by the monetary policy meeting summary, a 50bps rate hike is off the table now. "The Committee judges that some further modest tightening in monetary policy may be appropriate in the coming months." In February, the same line read that tightening was "likely to be appropriate." The BOE is sending the message that it prefers to tighten the economy slowly as the risk of stagflation surges amid a continuous rise in inflationary pressures and a slump in growth.
However, there is a problem with the BOE’s reasoning. Until the end of last year, the BOE was expected to be one of the most hawkish central banks in the developed world. Now it looks to be the most dovish, weighing negatively on cable, therefore welcoming more inflation.
That’s why the market is not buying into the BOE's statement. Before the monetary policy decision, investors were pricing the BOE base rate to soar up to 2.25% by 2022. After today's meeting, they see only five rate hikes pushing the base rate to 2%. If investors thought that the BOE could afford to be less aggressive, they would have boldly pared-back rate expectations for this year.
Looking at the other side of the Atlantic, the Federal Reserve’s message has been more explicit: the central bank will not stop until it has a hold of inflation. The dot plot completed the Fed's hawkish statement and almost matched the market's interest rate hikes expectations. Interestingly, the dot plot shows interest rates rising above the Fed's terminal rate by 40bps in 2023 and 2024, indicating that the central bank expects inflation to run hot longer than anticipated.
The big problem with the Fed's decision is that there is a stark contrast between the central bank's tightening agenda and its economic outlook. Although growth has been revised down from 4% to 2.8% this year, the Fed expects it to remain above 2% for the next three years. Even more surprising is the unemployment rate forecast, which shows unemployment will remain stable during the next couple of years, increasing from 3.5% to 3.6% in 2024. Envisioning growth and unemployment to remain stable while the central bank tightens the economy is wishful thinking. Indeed, reducing consumers' demand implies weak growth or higher unemployment, and neither features in the forecasts.
In conclusion, in the UK, the BOE realistically looks at the impact that high price pressures and the war in Ukraine might have on the economy but fails to recognize the danger of high inflation becoming entrenched. In the US, the Fed remains blind to the economic impact of high inflation and an aggressive tightening agenda, yet is willing to get a hold of price pressures.
Nevertheless, the bond market rightly signals that we might be approaching dangerous territory. Since yesterday's Fed meeting, the US yield curve between 5-year and 10-year briefly inverted. We believe that as the markets try to digest the Fed's message, an inversion in this area will consolidate and might bring more inversion in other parts of the US yield curve. Historically, an inverted yield curve has signaled a possible recession in 12 to 18 months. However, there is the risk that a downturn will come much before that, or even before an inversion occurs.
AI: The good, the bad, and the bubble
While a deep recession may not be iminent thanks to central bank policy, interest rates will have to stay high for longer, and this will be accompanied by volatility risk from the unwinding of bubbles, especially within AI.
Steen Jakobsen,
Chief Investment Officer
The emergence of advanced AI systems is by far the most surprising event this year, turning everything upside down, while risks and benefits are debated. AI will also become an arms race between the US and China.
Peter Garnry,
Head of Equity Strategy
As China navigates global fragmentation, its cycle of technology application, productivity enhancement, and growth is threatened by US breakthroughs in generative AI, limited computing power, and geopolitical tensions.
Redmond Wong,
Market Strategist
Japan’s expertise in semiconductors and robotic integration could be the foundation of AI dominance. Combining two of this year's themes, Japanese equities and artificial intelligence, brings a wave of opportunities.
Charu Chanana,
Market Strategist
The AI fever has turned the technology into a darling, pushing crypto further into no-man’s-land. There are striking similarities between AI and crypto, and if these are to come full circle, AI won't be spared for bubbles.
Mads Eberhardt,
Cryptocurrency Analyst
Stocks related to artificial intelligence (AI) have appeared on investors' radars. Expectations are high, but it may be necessary to consider how to get exposure to AI in a diversified way.
Hans Oudshoorn,
Trainer Academy
The USD is on its back foot as markets celebrate an eventual Fed rate peak and steady long US yields. The stakes are even higher for the Japanese yen if longer major sovereign yield curves have to price in economic acceleration.
John J. Hardy,
Head of FX Strategy
While commodities, broadly speaking, have faced some tough months, a partial reversal during June could signal that the asset class is getting back on its feet with energy holding up and precious metals with upside potential.
Ole S. Hansen,
Head of Commodity Strategy
As inflation remains high central banks face hard decisions about whether they should keep hiking interest rates or stop. Meanwhile, the rise of AI creates bubble-like conditions that only make the decision harder.
Althea Spinozzi,
Senior Fixed Income Strategist
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)
