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Weekly comment: Central banks react in bid to curb inflation

Date: 21 June 2022

Weekly podcast – Market overview

This week’s host, Equity Research Analyst, Oliver Creasey discusses the ups and downs of the past week with Head of Fixed Interest Research, Richard Carter and Head of Equity Research, Chris Beckett. Among the topics discussed – inflation, interest rates and what markets will focus on next.

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Market overview – Alan McIntosh, Chief Investment Strategist

Central banks stepped up their inflation fighting efforts last week, with the further hawkish shift weighing on investor sentiment and causing sizable selling in global equities. The MSCI All Country World Index declined over 5% on the week, taking its year-to-date drop to in excess of 20%. The latest communications from rate-setters also caused heightened volatility in bond markets, although yields closed a fair way from their highs due to the perceived negative impact of increasingly restrictive monetary policy on economic growth.

The standout event came from the US as the Federal Reserve announced its largest interest rate increase since 1994, hiking the benchmark policy rate by 75bp. In the weeks running up to the meeting the market almost universally expected a 50bp increase, in keeping with strong hints from voting members, but a new cycle high for inflation seemed to cause a shift towards an even larger move. The announcement itself actually saw stocks rally while bonds yields and the US dollar fell, as the 75bp move was flagged a couple days prior in a Wall Street Journal article that was widely seen as a case of informed reporting.

Another 75bp move is now viewed as the base case at the Fed’s next policy meeting and the policy rate is now expected by derivatives market to be around 4% by year-end, more than double the current 1.75%.  At the post-meeting press conference chair Jay Powell said that factors beyond the bank’s control, including higher commodity prices due to the war in Ukraine, could remove the possibility of a “softish” landing. Once more, US stocks underperformed their European and UK peers, with large-caps shedding over 5% on the week to fall pretty much in line with global equities. Friday’s closing level was the worst year-to-date total return since 1932 for US stocks.

After selling at the start of the week and gaining on the Fed news itself, stocks came back under pressure into the weekend and finished not far from their lows. Soft data on housing, with a 7% fall in building permits in May and a nearly 15% drop in housing starts increased concerns a recession could be in the offing, concerns that were further stoked by a 0.3% drop in last month’s retail sales.

Although bond yields rose heading into the Fed meeting, the US 10-year Treasury note hit its highest level in more than a decade at 3.49%, they retreated from their highs as the week wore on, paring the majority of the gains by Friday’s close, with the 10-year Treasury ending up 7bp at 3.23%. Look more closely at the fixed interest space and it’s apparent that markets are pricing in an increasing chance of a recession with credit spreads moving wider and inflation breakevens down sharply.

BoE tightens by another 25bp

For the fifth consecutive monetary policy meeting the Bank of England (BoE) decided to raise interest rates, meaning the central bank has delivered a 25bp hike at every meeting thus far this year. Three of the nine members of the rate-setting committee voted for a 50bp increase but, unlike the Fed, the majority decided to err on the dovish side with a smaller increase.

The BoE’s economic projections made for grim viewing. GDP is now expected to fall by 0.3% in the second quarter of the year and inflation forecast to top 11% in October, revising down the pace of economic growth and increasing predicted inflation compared to last month’s forecasts.

On the economic data front the UK labour market remains strong. A rise in the unemployment rate is likely seen as a positive from the BoE, due to the increase being attributed to more people re-joining the workforce. This could be seen as a possible disinflationary force, should it persist, and is also supported in this regard by figures suggesting that wage growth may be cooling.

Declines of a little over 4% for UK large-cap stocks on the week saw benchmarks move into negative territory for the year, although they are still strongly outperforming several notable peers. The pound also fell against the US dollar, depreciating around 1% to end the week at 1.22. Government bond yields rose, albeit in a fairly subdued manner, with the 10-year Gilt ending up 5bp at 2.50%.

Range of responses

Along with the Fed and BOE meetings there were also scheduled policy decisions from the Bank of Japan and Swiss National Bank, while the European Central Bank (ECB) convened for an unscheduled meeting in response to growing concerns relating to the divergence of member states’ sovereign bonds.

Despite the emergency nature of the ECB meeting no action was taken, although a statement indicated a willingness to undertake measures relating to the reinvestment of the proceeds from maturing debt in a bid to contain rising bond yields of the more heavily indebted member states. The Governing Council strongly hinted at a greater inclination to reinvest proceeds from peripheral higher-yielding countries, such as Italy, rather than the likes of Germany. The ECB is also seeking to develop a new policy tool to alleviate what it calls the “fragmentation” in borrowing costs. 

European shares declined around 4.5% on the week, with French and German benchmarks falling slightly more than average and Italian bourses outperforming. The German 10-year rose 14bp to 1.66% on the week. The Swiss National Bank caught out some investors by unexpectedly raising interest rates for the first time in 15 years. The 50bp hike means the benchmark rate is now at -0.25% and the move contributed to a swift move higher in the Swiss franc.

In a world where most major central banks are tightening monetary policy the Bank of Japan continues to stand pat, keeping its overnight rate at -0.1% at its June policy meeting. Furthermore, the bank said it will continue its policy of yield curve control, conducting daily purchases of 10-year Japanese government bond at a yield of 0.25%. Despite rising inflation and a large, recent depreciation in the yen, the Bank of Japan reiterated it is in easing mode, prolonging its monetary policy divergence from its peers.  

Speakers

Chris Beckett

Head of Equity Research

Oliver Creasey

Equity Research Analyst
Richard Carter

Richard Carter

Head of Fixed Interest Research

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