- Threat of higher prices triggering a wage spiral is troubling policymakers
- Some think NextGenerationEU will help avoid a new debt crisis in Southern Europe
- Gloomy forecast for sterling; more upbeat for dollar
Not often far from the action, central banks have been centre stage in 2022 as one after another in the developed markets reveal their hawkish intents. The speed and synchronicity with which they have shifted has been pretty remarkable, with only the Bank of Japan not yet joining other main central banks.
There is no denying that inflation has risen sharply, with the European measure of inflation, the harmonised index of consumer prices (HICP), reaching an all-time high for the region of 5.1%. The European Central Bank’s quarterly Survey of Professional Forecasters also highlighted the very sharp move higher in inflation expectations for 2022 (see figure), with ECB president Christine Lagarde talking of “universal concern around inflation data”.
The threat of higher prices triggering a wage spiral will be troubling for policymakers around the world. Although the headline jobs gain in January’s US employment report took markets by surprise, the 0.7% increase in average hourly earnings was perhaps the more influential figure.
For now, the consensus appears to be that longer-term inflation expectations are still well anchored, and that the current surge in prices and wages will plateau.
Central bank actions in emerging markets (normally a heterogeneous group) have been more diverse.
Lower-yielding economies, such as South Korea and the Czech Republic, have also tightened policies in response to the higher inflation data. Brazil and other Latin American economies are also having to respond to significantly higher inflation data, but with the additional risk of far inferior fiscal situations.
For China, the Winter Olympics are unlikely to provide an economic boost and instead might be a negative, given China’s strict COVID measures. Recent figures point to slowing economic activity in the first quarter of 2022, and any central bank action is therefore likely to be on hold for now.
Is the US heading for a yield curve inversion?
As central banks have tightened their monetary policies, so yield curves have been flattening, some quite dramatically. This has prompted a great deal of talk about the possibility of the US curve being poised to invert.
Historically, an inverted US yield curve has provided a reliable forewarning of recession, with few false signals. However, quan- titative easing and huge Central Bank balance sheets have meant that using the crystal ball of yield curve inversion may be less effective today.
In the past, curve inversion would precede the start of recession by one or two years, much earlier than, say, credit spreads or stock market returns might indicate. It is therefore a good warning signal when other indicators are still pointing to above-trend growth.
Yield curves started to flatten before the Fed began its tightening cycle, and this is certainly what was seen in 2017-18, as longer rates anticipated the coming shift in policy. This time, however, the flattening has been even more dramatic and faster, prompting investors to pause and wonder why.
There are two fairly obvious reasons why longer-term interest rates remain, arguably, lower than they should be. The first is the Fed’s balance sheet, and the direct correlation between the size of its Treasury holdings and the downward pressure on interest rates.
Another important factor is the ongoing demand for longer- dated securities to support pension funds in their liability-driven investment efforts.
Although we may be close to inversion, there is some way to go.
An inverted curve implies that policy is too tight, and a hard landing is likely. But with rates yet to be increased, and still near zero, it may be that today’s flat yield curves need to be even flatter and that the level of shorter rates may hold more information than they did pre-quantitative easing.
The global stock of negative yielding fixed-income assets has been falling for some time. In February even the 10-year Bund yield climbed into positive territory, after the ECB revealed its more hawkish stance.
The market has moved to price in a cumulative 50bps of ECB rate hikes this year, and it is likely that repricing is not yet done.
Peripheral spreads, not something the US Federal Reserve has to worry about, have been widening sharply too. The less robust fundamentals of the Southern European bond markets come under more scrutiny as ECB policy is tightened, liquidity deteriorates and funding costs rise.
Maybe it is too pessimistic to fear the onset of another European debt crisis. A more optimistic view could be that the north-south transfers from the EU’s recovery plan, the NextGenerationEU, will provide welcome support. Economic growth is predicted to be strong this year and in 2023, which can also provide protection against widening peripheral spreads.
For bond markets generally, a lot of investor focus will be on whether US wage growth is near to peaking, or if there is danger of it persisting or even worsening. The latter would cause the Fed to tighten policy much further, risking a significant economic slowdown and potentially causing a lot of upset in the financial markets.
The Bank of England’s Monetary Policy Committee (MPC) in early February announced its reasonably well-heralded 25bps rate hike to 0.5% – the second rise in three months. It was subsequently revealed that four of the nine MPC members had voted for a 50bps increase, a hawkish revelation that took many by surprise.
While there is a case that policy rates should be raised faster than previously forecast, the BoE governor emphasised a “modest tightening ” over the coming months, continuing to push back against more hawkish market expectations over the medium term.
This front-loading of interest rate hikes could provide some near-term support for sterling, especially versus other G10 economies whose central banks are plotting a slower rate trajectory. However, the outlook for the UK remains gloomy, with the BoE downgrading its sterling forecasts on the back of higher expected rates as well as the substantial income squeeze facing the UK consumer.
“The outlook for the UK remains gloomy, with the BoE down-grading its sterling forecasts on the back of higher expected rates as well as the substantial income squeeze facing the UK consumer”
The US dollar’s exceptionalist credentials may be diminished as interest rates around the world rise. However, some forecasters believe it is too early to be calling the top, arguing that, although its peak may indeed be nearer, it has not been reached.
US payroll data point to an economy showing considerable strength, and much nearer to closing the output gap than other economies. US dollar bulls argue that the Fed will need to tighten more than is currently priced into the market. They also argue that the Fed is more likely, and able, to be more aggressive than the ECB, which has to be more careful, given previous bouts of tightening and the potentially damaging impact on peripheral bond markets.
Where there may be more agreement is that a world in which global financial conditions are tightening will likely lead to more volatility in foreign exchange markets and put the vulnerabilities of high-beta currencies into sharper focus.