A remarkably rapid tightening of monetary policy by leading central banks has been the dominant theme for financial markets in 2022. The recent publication of the minutes of their latest meetings set the scene for the final monetary policy gatherings of the US Federal Reserve (on 13-14 December) and the European Central Bank (on 15 December). The stage now seems set for a slowing in the pace of policy tightening on both sides of the Atlantic.
The minutes for the ECB’s October meeting show broad support among members of the governing council for a 0.75% rate rise, after eurozone inflation had surged to 9.9% year-on-year in September. It was the ECB’s second successive police rate increase by 0.75%. Its rate rising cycle began in July, when the central bank raised its key deposit rate from negative 0.50% to zero.
The latest set of minutes show ECB policymakers saw the risks as tilted to the upside over the entire projection horizon. Indeed, since the October meeting, inflation in the eurozone has again surprised to the upside: it hit a record 10.6% in the year to October, reflecting soaring energy and food prices in the wake of Russia’s invasion of Ukraine.
Policymakers at the ECB noted last month that with the 0.75% hike, substantial progress in withdrawing monetary policy accommodation had been made. This suggested that a slower pace of hikes could lie ahead. We expect the ECB to again raise its policy rate by 0.75% in December to 2.25% with further rises of 0.50% in February and 0.25% in March taking the rate to a terminal level of 3%.
The ECB has made clear that the pace of hikes will be generally data-dependent and be decided in a meeting-by-meeting approach. Particularly attention will be paid to risks of a wage-price spiral.
A new data set from the Central Bank of Ireland uses developments in wages posted in job adverts on the basis that they can be a timely and forward-looking indicator of wage growth trends. The theory is that as posted wages tend to be more sensitive to the economic cycle, they can shed light on the tightness of the labour market. The wages of new hires are also an indication of the expectations of employers in terms of future demand.
Currently, the data suggests that wage growth is plateauing at historical highs — and is actually falling in some countries (see Exhibit 1 below). Combined with gradually declining job postings in certain countries, this may mean that some employers are starting to rethink their demand for labour as they balance the currently tight labour market against an increasingly uncertain and deteriorating economic outlook in Europe.
Preparing for a downshift at the Fed?
Minutes from the November meeting of the Federal Open Markets Committee (FOMC), at which the Fed raised its benchmark rate by 0.75% for the fourth time in a row, suggest policymakers are committed to pursuing their efforts to rein in high inflation.
However, the report also signalled that the FOMC is prepared to start raising rates in smaller increments to assess the economic effect of an extremely aggressive tightening campaign:
“A slower pace in these circumstances would better allow the committee to assess progress toward its goals of maximum employment and price stability”
While it is clear that that interest rate-sensitive sectors of the US economy, such as housing, have adjusted quickly to higher policy rates, the timing of the effects on overall economic activity, the labour market, and inflation remains uncertain.
According to the minutes, a ‘substantial majority’ of Fed officials support slowing the pace of rate rises soon. We expect the FOMC to raise the federal funds rate by 0.50% from the current 3.75-4% in December, followed by another 0.50% in February, and then 0.25% in March 2023. That would mean the fed funds rate tops out this cycle at 5-5.25%. That is well above the 4.6% expected by most Fed officials just two months ago.
US growth slowing versus Europe?
Data for US purchasing manager indices (PMIs) released this week was below expectations and US jobless claims rose, while the eurozone PMIs surprised to the upside.
The preliminary November S&P PMI reports for US manufacturing and services fell to 47.6 (from 50.4 last month) and 46.1 (47.8 last month), respectively. This would be the first time the manufacturing composite index is in contractionary territory since 2020 (a reading below 50 indicating contraction, while a reading above 50 is considered to indicate expansion).
In contrast, the eurozone manufacturing PMI rose from 46.4 in October to 47.3 in November, while the PMI for services was stable at 48.6. The PMI composite improved from 47.3 to 47.8. At these levels, the PMIs remain in mild recession territory, but the data suggests continued resilience in the economy.
This impression is reinforced by other recent data including an improvement in the German Ifo Business Climate Index suggesting that economic sentiment in Germany is stabilising. This perhaps reflects the progress Germany has made towards becoming independent of Russian gas as well as the extent of fiscal support measures.
Germany’s economy is still expected to enter recession this quarter, but government support may succeed in achieving a milder recession than looked likely earlier this year.
Overall, this data raises the question as to whether inflation momentum is shifting from US to the rest of the world with potential consequences for the US dollar in foreign exchange markets.
Value is back in fixed income
As outlined in our 2023 Investment Outlook, nominal bond yields now offer attractive carry and real yields have moved significantly higher. Central banks have managed to drive interest rates to normalised levels, meaning the bulk of rate rises is behind us now. Five year-five year real yields in the US and the eurozone have returned to their post-Global Financial Crisis highs.
We believe that taking advantage of opportunities to pick up incremental yield will be essential in generating returns in 2023. As the transition to the new bond world is not complete, volatility will likely remain high and asset allocation is crucial.
We expect 2023 to see both growth and inflation decelerate and accelerate, calling for different allocations depending on the macroeconomic regime.
We see eurozone investment-grade credit as attractive as spreads are commensurate with much higher default rates than we think will actually materialise.