March 18 2022
Central banks were at the fore this week, with meetings at the Bank of England and the US Federal Reserve. The Bank of England, as expected, increased the base rate by a further 0.25%, taking it to 0.75%. The MPC voted 8-1 in favour of the move, with one dissenter voting to keep the rate unchanged. This move now takes the rate back to pre-COVID levels.Developments since the invasion of Ukraine, and the reaction we have seen in commodity prices in particular, is likely to mean that inflation will move higher, potentially to c.8% in the second quarter of this year. Given the robust domestic cost and prices pressures, the risk that those pressures will persist, along with the current tightness in the labour market, the MPC voted that a rate rise was warranted. They also recognised that some further modest tightening may be needed in the coming months, but acknowledged that there are risks on both sides, and that such moves would be made depending on how the medium term prospects for inflation evolve. This is somewhat dovish compared to the statement from the previous meeting. Higher inflation is likely to have a detrimental impact on economic growth.
The Federal Reserve also voted in favour of a rate rise, lifting by 0.25% to a range of 0.25% to 0.50%. This was again in line with market expectations, with some commentators having being predicting a 0.5% increase prior to the Ukraine conflict. They now see an interest rate hike at each of the remaining meetings for the year of 0.25%, taking rates to 2% by year end.
This is in response to a higher than expected PCE inflation, which they now forecast at 4.3% in 2022, compared to the 2.6% made in their December projection. The median of the Fed’s new dot plot projections suggests a further three rate hikes of 0.25% in 2023. This hints that they are being more aggressive with monetary policy, especially when they also expect to start reducing their holdings of Treasury securities, agency debt and agency mortgage backed securities.
Perhaps the clearest sign that the Federal Reserve is focussed on inflation for now was the statement from Chair Powell that they find the current level of labour market tightness is unhealthy. This perhaps suggests there are concerns that wages inflation could prove higher and more persistent, which could lead to more general inflation becoming more entrenched.
A period of normalisation in interest rates should be taken as exactly that, normal. We have been through an extended period of very low interest rates as central banks looked to support global economies from one crisis the next. Indeed, when central banks were unable to raise interest rates sufficiently as we escaped previous crisis they came under a great deal of criticism. The concern this time is perhaps that central banks will move too aggressively in order to try and contain inflation, some of which is supply rather than demand driven. From COVID to the Ukraine conflict, there has been substantial disruption to many supply chains. Being too aggressive with rate hikes may choke economic growth.
The most visible reaction to the rate rises and forecasts have been seen in bond markets. We had already seen yield curves flatten ahead of the event and have continued further subsequently. In the US, although less followed, the yield between the 10 year and 3 year Treasury is now as good as zero.
The more widely followed barometer is the spread between the 10 year and 2 year Treasury. At the time of writing the 10 year yields 2.16% whilst the 2 year yields 1.93%, giving us a spread of 0.23%. Whilst the short end of the yield curve is pricing in forecast interest rate hikes, the longer end of the yield curve appears to be suggesting that inflation will rollover and that interest rates rises could suppress growth. To quote Mark Twain, “history doesn’t repeat itself, but it often rhymes,” and previous occasions where the 2 year yield has exceeded the 10 year yield have predicated a US recession. Something to watch, therefore.
No one likes a recession, including equity markets. Research from Goldman Sachs shows that around the twelve recessions since World War II the median peak to trough decline in the S&P 500 has been 24%. The range is large however, with a 15% fall in 1953 compared to a 57% fall in 2008. The peak to trough in months however has ranged from only 1 month (1980 and 2020) to 30 months (2001).
It has certainly been a volatile week in certain assets classes. After finally re-opening to nickel trading, the London Metal Exchange had to close almost immediately as the price plummeted. We also saw a lot of volatility in the Hang Seng market this week. On Monday the market fell 4.97%, followed swiftly by a fall of 5.72% on Tuesday. Wednesday however saw the market recover 9.08%, with a further 7.04% rise on Thursday. After a rather rocky week, the index closed its Friday trading at 21,412.4, a rise of 4.18% on last Friday.
Volatility, for now, appears here to stay, but which asset class, market or region will it be next? Two quotes come to mind, the first from Peter Bernstein, “The history of markets is one of overreaction in both directions”. The second from meanwhile comes from Benjamin Graham, “The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism.”
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