Post Central Bank Meetings: What's Next?
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The Fed decided to go bold and go against its initial guidance by raising policy rates by 75bps to 1.5-1.75% at its June meeting. The surprisingly high CPI inflation print of May after which market expectations changed immediately and the rise in the 5-10-year consumer inflation expectations from the University of Michigan may have also forced their hand. The Fed cannot allow high inflation to become entrenched. It must therefore proceed with massive rate hikes to show its commitment to bringing inflation back to the 2% target and maintain its credibility. The median rate forecast from Fed members suggests that the Fed will raise rates to 3.4% by the end of the year (which is much higher than the neutral or long-term equilibrium rate which is estimated to be around 2.5%) and only modestly in 2023 to 3.8%, before cutting rates in 2024 to 3.4% . Our growth forecasts for the US have gone down from by 1.1% to +2.6% in 2021 and cut by -0.6% to +1.9% for 2022. On the other hand, our inflation forecasts have gone up by 1.0% for 2022 to +7.5% and by +1.1% to +3.9% in 2023.
By end-2022: Our forecast is for Fed funds rate of 3.5% (terminal rate) by end of 2022.
- Jul: 75bp
- Sep: 50bp
- Nov: 25bp
- Dec: 25bp
This puts the policy rate at 3.5% by the end of the year and this should be the highest level for this cycle (terminal rate). Our assumptions are slightly less aggressive than the market's, which expects 3.65% by the end of 2022 and 3.9% by the end of 2023. As implied by the Fed, we also envisage some rate cuts by the end of 2023, as the Fed will no longer focus on fighting inflation but on preventing a recession.
US Treasury yield 12-month target (a flat curve): In terms of bond yields, we expect a flat yield curve in 12 months time, suggesting that the risk of recession has increased significantly. Remain cautious and neutral on global equities as the reasoning behind the downgrade back in February was higher than expected inflation and interest rates have been key catalysts that worsened. Also to repeat again the central bank “put” as a result is lower than the market anticipates.
Treasury Yield Targets:
- 2Y: 3.25%
- 10Y: 3.25%
The ECB held an extraordinary meeting on 15 June, barely a week after its monetary policy meeting, to stop the bleeding in the markets, and in particular the rapid rise in Italian long rates and the tensions on Italian spreads (yield spreads between Italian and German bonds). Our updated gdp forecasts are 2.5% for 2022 a cut of -0.3% and 2.3% in 2023 a drop of -0.4%. Inflation increases by +0.6% to 7.9% in 2022 and +0.1% in 4.1% in 2023.
The ECB decided to use the reinvestment flexibility of the pandemic bond buying programme PEPP. In practice, it means they will redirect all the weekly reinvestments not according to the ECB capital key, but rather to one or a few countries whose spreads have widened too much, like Italian bonds. However, this tool has its limits when several countries are under stress, as the amounts may be too small, unevenly distributed over time and the tool lacks a signal effect. In addition, the ECB mandated a working group to accelerate the completion of a new anti-fragmentation tool. The wording suggests that this anti-fragmentation tool could be announced in the coming weeks.
Both tools will allow the ECB to pursue its plan to raise policy rates, even aggressively, without triggering a sharp sell-off in peripheral bonds. This gives more credibility to the ECB's policy stance.
Forecasts on ECB rate hikes:
- Jul: 25bp
- Sep: 50bp
- Oct: 50bp
- Dec: 25bp; Therefore, By end-2022: deposit rate 1%; refi rate 1.25%
- 2023: 4 hikes of 25 bps
- By end-2023: deposit rate 2%; refi rate 2.25%.
This pace of rate hikes is slightly conservative compared to the market, which expects the deposit rate to be 1.3% by the end of this year and 2.3% by the end of next year. We assume that the main refinancing rate will be 0.25% above the deposit rate.
German Bund Yield Targets:
- 2Y: 1.50%
- 10Y: 1.75%
Global growth forecasts have been revised down while inflation forecasts have been revised up. We expect a quasi-stagnation, & risk of recession is getting higher in Europe relative to the US.
Credit – Gradually extend duration despite hawkish Fed Why?
- Focus on Developed Market (DM) Investment Grade (IG) bonds
- Diversify away from weak or expensive Asian credits valuation if you have excess concentration risk in China credits
- After yield rise can increase more 4-6 Year developed market financial bonds – 4.5% to 5.0% offers good carry, be selective.
During economic slowdowns and recession high quality Investment grade credit on average, where we are neutral, outperforms both equities and high yield credit. Remain cautious and neutral on global equities as the reasoning behind the downgrade way back in February was higher than expected inflation and interest rates. Bear market rallies will occur, we are heading into month-end and but should be used to increase the quality of portfolio.
Take advantage of the High Implied Volatility in foreign exchange markets:
- There is high volatility, with many central banks raising rates, and divergent policies like the BOJ
- As appropriate take advantage to monetize this volatility