Rates round-up

Overview

A busy fortnight for the big central banks may not have changed much. Interest rates are turning a corner, but more slowly than money markets have been expecting – even as inflation continues to subside.

Policy rates had already been significantly 'higher for longer' than the consensus expected when they started to rise in late 2021 and early 2022. They are turning out to be higher for even longer. And in the spirit of open-mindedness, we have to note that they might yet turn out to be even higher for even longer. In other words: they may not have peaked definitively, though that is not our call.

Why are US and (most) European interest rates proving stickier than inflation? Two reasons: unemployment is still low, and central bank credibility is being rebuilt.

The decline in inflation to date has been led by the unwinding of the supply-side component – by the passing of post-pandemic supply shortages, and by the collapse of European natural gas prices after the Ukraine-led spike. As yet, the higher shipping costs caused by the more recent trauma in the Middle East do not seem to be reversing much of this disinflation – as we'd guessed they mightn't.

Wider inflation has also faded, but less conclusively. In particular, wage growth remains elevated. Not as much as it could have been, for sure: remember the talk of '1970s-style wage-price spirals? But having risen a bit, it has yet to return to its more subdued starting point, whether in the US, the eurozone or the UK.

Pay growth can slow further even if unemployment stays low. As we have noted, western labour markets seem to behave differently these days – it is as if the workforce has collectively traded stable real pay for more stable employment. The so-called 'non-accelerating inflation rate of unemployment' (NAIRU) may be lower than it used to be. Moreover, the initial slump in real pay is now behind us, as prices have slowed sharply, making it easier for the workforce to accept slower nominal wage growth.

Unfortunately, the big central banks already bet once on a low NAIRU, prematurely: They let historically-low interest rates coincide with historically-low unemployment in 2021. They will not rush to place that bet again.

If unemployment were rising meaningfully, they would be more likely to cut rates. Even then, however, their decision-making might be shadowed by that mistake, which has likely raised the bar for monetary easing in most circumstances. There have been no hyperdeflations, and that one-sided monetary risk needs to be more visibly reflected in policy stances.

None of this closes the door on rate cuts in the months ahead, as we shall see. But it has argued for keeping both bond optimism, and overall macro risk appetite, in check. And while we do not expect it, that door could indeed be closed if inflation risk were to revive.

Hawks, doves, none of the above

In their latest meetings, the three central banks most important to our clients' portfolios each left policy rates intact, though their individual positions were more nuanced.

Arguably, there are no outright 'hawks' these days, but the nearest thing to one currently might be the US Federal Reserve. In leaving its policy rate at 5.25-5.5% for now, it commented that it doesn't yet have "higher confidence" that inflation is falling sustainably, though members of its monetary committee indicated that they do expect rates to fall three times (for a total of 0.75 percentage points) later in the year.

The European Central Bank (ECB) (at 4%) meanwhile had earlier suggested that a June cut might be in the offing, depending on pending wage data, with some individual ECB rate setters suggesting an earlier cut is still possible. As in the US, several cuts are likely by year end.
The Bank of England (BoE) (at 5.25%) perhaps looks the keenest to start cutting. Two committee members shelved calls for higher rates, and in a subsequent interview the Governor seemed to encourage the idea that rates are 'in play' now, drawing attention to that NAIRU point above.

These views may change, of course. Central banks are no better at predicting the future, or understanding how economies work, than the rest of us (not because they're not extra-smart, but because these are not tasks which can be much improved by extra-smartness). But for now they suggest that the first rate cuts – from the ECB or BoE? – may still be a month or three away.

We would not advise trading money market contracts on this. For us it suggests simply that much of the USD/EUR/GBP yield curve currently is neither bargain nor bubble. And for global portfolios, it is the Fed which matters most, of course.

Elsewhere, the Swiss National Bank (SNB) bucked this trend, breaking ranks with a 25 percentage point rate cut to 1.5%. We did not expect the move, but were not hugely surprised by it – and neither were the local capital markets, to judge by the response.

Across a wide range of indicators, Switzerland was the best-performing developed economy in the scorecard we produced last May. Swiss inflation peaked at just 3.5% in August 2022, and is currently at 1.2%. Until the New Year, the franc had been trending higher, arguably adding to the monetary tightening delivered by the SNB's cumulative 2.50 percentage point hike in rates. The SNB's credibility has not been in doubt to begin with. Note that a small federal government and sound money alone are not necessarily attractive to equity investors…

The Swiss franc has now fallen 5% or so from its trade-weighted peak, reintroducing some uncertainty, and perhaps restraining the sort of potentially destabilising inflows we have seen in the past.

The Bank of Japan (BoJ) broke ranks in the other direction – or was it belatedly catching-up with what the rest have been doing? – by raising rates from -0.1% to a target of between 0 and 0.1%, its first move since early 2016, and its first hike since early 2007. It brings to an end the last negative policy rate still in place.

To be fair, in not raising rates earlier it had not much damaged its credibility, because (as with the SNB) there has been little local inflation: after two decades of deflation (to 2020), it rose to peak at just 4.4% in early 2023.
We're only discussing Japan here because its economy and bond market are such a preoccupation for so many pundits – a focus out of all proportion to their investment importance. Arguably, economists should have been talking not so much about the 'Japanification' (awful word) of the West, but about the likely 'Westernisation' of Japan…

It was never clear why a few basis points on the local side of a supposedly popular international carry trade should have more impact on flows than hundreds of basis points on the other side. The lack of a wider response to this supposedly epochal event is not surprising.

Japan's economy is unique, not being conventionally capitalist to begin with, and its reported struggles with a supposed 'balance sheet recession' (an awful phrase) have surely reflected local idiosyncrasies rather than some yet-to-be-discovered general law. Those struggles have seen it actively pursuing more inflation, and the rate remains above the BoJ's long-standing objective of 2%.

As they say, be careful what you wish for. For now, though, as noted, Japan's monetary credibility – despite its gyrating exchange rate – remains intact. And while Japan may have been largely marking time in recent years, it is still a relatively prosperous, and socially at ease, country. Whatever may be wrong with its economy, I doubt it has much to do with the earlier deflation, which looks economically and statistically insignificant (it is within the realm of measurement error).

Finally, the People's Bank of China may not have been in action this last fortnight, but it has been effectively loosening policy for several months now – mostly by cutting required levels of bank reserves, but also by trimming key policy rates. As with the SNB and BoJ, it has been able to plough its own monetary furrow because its inflation cycle has been so benign.

Ongoing monetary loosening may yet support the local economy stock market – the jury is still out – but we no longer carry a top-down torch for that. It is more likely to help the bond market, but as with Japan, that is a long way to travel (in terms of risk, rather than kilometres) for such a small yield.

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