#Market Strategy — 24.03.2023

Fed and ECB: Stay the Course

Edouard Desbonnets, Senior Investment Strategist


No surprises from the Fed or ECB. They raised rates due to high inflation and reassured the markets about the risk of banking stability.

We are keeping our end-of-cycle rate forecasts at 5.25% in May for the Fed and 3.50% (deposit rate) in June for the ECB. The market has moved closer to our end-of-cycle rate forecasts. However, contrary to market expectations, we do not expect the Fed to cut rates this year.

We believe that German and US interest rates will rise in the next few months before falling due to the economic slowdown. Our targets are 3.5% for the US 10-year interest rate and 2.5% for its German counterpart.

Rates have plummeted almost historically since the banking crisis that began nearly two weeks ago. We moved to Neutral from Positive on US government bonds and short-term eurozone government bonds on 21 March after the sharp drop in rates


25 basis points: Fed members were offered two options by Fed economists at the 22 March monetary policy meeting, raise key rates by 25bp or a pause. The first option was adopted unanimously, bringing the key rate to 5% (upper range). The second option would probably have been interpreted as a sign of a lack of confidence in the soundness of the banking system.

Banking instability: the subject was obviously at the forefront following the bankruptcy of three US regional banks in early March. Fed Chair Powell wanted to be reassuring, recalling the measures already taken by the Fed, the Treasury and the Federal Deposit Insurance Corporation (FDIC) to restore confidence and avoid a bank run.

Policy rate trajectory: the statement suggests the need to raise rates less than initially expected. The reason is that the recent banking crisis will likely lead to a tightening of credit conditions for households and businesses, and weigh on economic activity, hiring, and inflation. Thus, the tightening of credit conditions will have the same effect as interest rate increases, but in proportions that are still unknown (50bp?).

The median rate projections of the 18 Fed members indicate a key rate of 5.1% at the end of the year (unchanged from the December 2022 projections), 4.3% at the end of 2024 (versus to 4.1% in December 2022) and 3.1% at the end of 2025 (unchanged). However, there is a very large dispersion in the rate projections of each of the Fed members for 2024 and 2025.

Our view on the Fed: the Fed's caution and the expected tightening of credit conditions caused by the banking crisis suggest that the end of the rate hike is close. We continue to expect a 25bp rate hike at the next meeting in May, which would take the key rate to 5.25%. We believe that the Fed will maintain this end-of-cycle rate throughout the year to avoid what happened in the ‘80s, when the Fed lowered rates too early and inflation returned. The market has moved very close to our end-of-cycle rate expectations for May but not at all thereafter, as it expects 60bp in rate cuts by the end of the year.

Our view on US interest rates: short- and long-term rates have plummeted almost historically since the banking crisis began nearly two weeks ago, and then a little more after the Fed meeting. We expect rates to rebound in the next few months as we are not facing a repeat of the global financial crisis and we believe that the market will revise its expectations towards fewer rate cuts. We expect a 2-year interest rate of 4.5% and a 10-year interest rate close to 4% in 3 months. Interest rates should then fall (12-month targets of 3.75% and 3.5% for 2-year and 10-year interest rates respectively) due to the impact of tighter credit conditions and the economic slowdown. We moved to Neutral from Positive on US government bonds on 21 March after the sharp drop in interest rates.


Decision as expected: despite the very tense market environment with the bankruptcy of three regional banks in the United States and the difficult situation of Credit Suisse, the ECB increased its key rates by 50bp at the 16 March meeting, as announced several weeks beforehand, due to the rise in inflation. The deposit rate was therefore raised to 3% and the main refinancing rate to 3.5%.

One instrument by objective: the rise in policy rates is the response to inflation deemed “too high for too long”. In response to financial instability, the ECB has promised liquidity injections if necessary.

End of forward guidance: the ECB did not want to make any forecasts on the evolution of key rates in the coming months because of the high level of uncertainty. Its future decisions will depend on four factors: i) the inflation outlook; ii) the dynamics of core inflation and iii) the effectiveness of the transmission of monetary policy. To this, we add iv) the stability of the financial system.

Our view on the ECB: i) regarding inflation, we note the downward revision of the ECB's inflation forecasts despite an upward revision of GDP growth; ii) regarding core inflation, ECB forecasts point to a rate slightly above the 2% medium-term objective. We expect core inflation to remain elevated for several more months before decelerating only towards Q3. Moreover, iii) regarding the smooth transmission of monetary policy, the ECB notes a decline in the dynamics of loan growth and a tightening of credit conditions. Finally, iv) regarding the stability of the financial system, stress has greatly diminished.

As a result, we believe that the ECB will continue to raise its key rates due to persistent inflationary pressures, while continuing to reassure the markets about the risk of financial instability with specific measures if necessary (cheap short-term loans in euros, funding in dollars, etc.).

We still expect a 25bp rate hike at each of the next two meetings (May and June), and an end-of-cycle rate of 3.5% in June. Market expectations for the end-of-cycle rate have risen over the past few days to 3.55% from 3% and are now fully aligned with our view. We do not expect any rate cuts this year.

Our view on German interest rates: short- and long-term rates have plummeted to historic proportions since the banking crisis that began nearly two weeks ago. We expect interest rates to rebound in 3 months, to 3% for the 2-year interest rate and close to 2.75% for the 10-year interest rate. Subsequently, we think rates will fall again, in line with the slowdown of the economy. Our 12-month target is 2.50% for both the 2-year and 10-year interest rates. We moved from Positive to Neutral on eurozone short-term government bonds on 21 March, after the sharp drop in interest rates over the last two weeks. We remain Neutral on long dated government bonds.