Head of Fixed Income Strategy
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.
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