Global Interest Rate Hikes Set to Slow

 | Dec 02, 2022 05:21AM ET

As the year of aggressive monetary tightening winds down, the Federal Reserve, the European Central Bank, and the Bank of England will likely slow the pace of rate hikes. All three delivered 75 bp hikes in November and will probably hike by 50 bp this month and moderate the pace again in the first part of next year.

Price pressures remain elevated even if near or slightly past the peaks. The G10 central banks are not finished tightening, though central banks from several emerging markets, including Brazil, Chile, and Czech, may be done. The fact that the UK and the eurozone have likely entered a recession will not prevent the Bank of England or the European Central Bank from tightening further. The US economy has proven quite resilient after contracting in the first half when companies found it difficult to manage inventories with the supply chain disruptions. However, the tightening of financial conditions, the inversion of the 3-month/18-month curve that Federal Reserve Chair Powell highlighted, and weakening global demand warn that the US economy may not be out of the woods.

The labor market's strength gave the Federal Reserve the encouragement to engage in the most aggressive tightening in its history. Counting the 50 bp move in December that has been signaled by Fed officials and fully anticipated by the market, it would bring the hikes to a cumulative 350 bp in the past seven months, and its balance sheet is unwinding faster than it did after the Great Financial Crisis. Last December, the Fed's Summary of Economic Projections had the median dot for the end of 2022, Fed funds at a little less than 1%. The two highest dots were at 1.125%. Instead, the year-end target range will most likely be 4.25%-4.50%. A year ago, the median projection was for Fed funds to be 1.6% at the end of 2023. In September, it was 4.6%, and the December iteration will likely be 5%, if not a little higher. 

Still, despite the market expectation of the terminal rate to be closer to 5% than 4.5%, which it had discounted at the end of September, and the more hawkish Fed stance, the derivatives market continues to price a Fed rate cut in Q4 23. Fed rhetoric cautions against expectations of a cut but investors and businesses are concerned about the economic outlook. There are several yellow flags. First, there is that the long-end of the curve is now below the Fed funds target and the other inversions are associated with recession conditions.  Second, there is a string of eight consecutive monthly declines in the Leading Economic Index and five months that the Composite PMI has been below the 50 boom/bust level. Third, the ISM services index has been trending lower since the end of Q1 and, in October, has fallen to its lowest level since May 2020.

Get The News You Want
Read market moving news with a personalized feed of stocks you care about.
Get The App

Investors who are more pessimistic toward the United States seem unreasonably optimistic toward China. There was a narrative that with Xi having secured his position (as if the 20th Party Congress granted rather than acknowledged it), he was free to pivot from zero-Covid, aiding the property sector more and rebuilding ties with the US and Europe. Although several large banks upgraded their outlook for Chinese equities within a couple of weeks of the end of the Congress, we are more skeptical of each of the so-called pivots.

China's zero-Covid policy is not simply the result of overzealous officials. Still, it is also a reflection of its poor health infrastructure and its inability, according to domestic and international doctors, to cope with the like surge in cases that would likely accompany as significant relaxation. It deals with a weaker vaccine and reportedly low inoculation rates, especially among the elderly. Hong Kong, which was supposed to be the model, is experiencing a powerful surge, and its hospitals have had to turn around non-emergency procedures starting in late November. The rise in infections has laid to rest an idea of a meaningful shift from the zero-Covid stance. Still Beijing has pushed back against what it sees as overzealous local officials.  

New measures were announced to support the property market. Yet not only is there a gap between declaratory and operational policy, but we are not convinced that excess capacity is addressed by the new measures, which seem aimed at reflating the property market from the supply side. For many years, the critical role it played in Chinese development, growth, and investment led to excesses that have not been absorbed. Investors also are optimistic that China's relative isolation on the world stage is ending. This seems to be the most ill-founded of the three hopes/wishes. China indeed signed on to the recent G20 statement condemning the war in Ukraine, and the US and China have renewed bilateral climate talks. US Secretary of State Blinken will visit Beijing, and there have been other high-level talks.

Yet, this barely returns the relationship to where it was before US House Speaker Pelosi visited Taiwan. That China is critical of the war in Ukraine should not be surprising. The consequence, which includes a larger NATO, is a closer examination of Chinese state-owned-enterprises purchases of European and Canadian companies, especially in the infrastructure, mining, and technology areas. The US is determined to block China from acquiring the latest semiconductor chip capability, and recent data suggests it is beginning to bite. Still, the US practice of announcing sanctions and then seeking to secure support from its allies (cart, horse issue) could undermine the strategy, creating the kind of arbitrage room, as it were, between Europe and the US that China looks to exploit. We see little to detract from Henry Kissinger's observation that we are in the "foothills" of a new Cold War.

In addition to the Fed's tightening and China's Covid and property sector challenges, Japan's extraordinary monetary policy is a third element of the investment climate. Japan's headline CPI rose to 3.7% in October, matching its highest in 30 years. The Bank of Japan targets the core rate, which excludes fresh food. At 3.5% year-over-year, it has not been this high in forty years. Yet, the BOJ insists the price pressures are not sustainable and do not warrant a change in its negative overnight rate or Yield Curve Control, which caps the 10-year yield at 0.25%. The BOJ forecasts core CPI to fall to 1.6% next year, and the market concurs (the median forecast in Bloomberg's survey is 1.7%). Moreover, the market is more aggressive than the BOJ for 2024, when it sees core inflation falling to 1.0%, while the BOJ sees it steady at 1.6%.

Although capping the 10-year yield has distorted the market, the BOJ appears under little pressure to abandon it. The economy unexpectedly contracted in Q3 and appears off to a weak start in Q4. The government has provided new fiscal support, which may help support growth and limit price pressures. The 20-year government bond yield has fallen from nearly 1.33% in late October to less than 1.15% at the end of November. The 30-year bond yield has fallen a little more after peaking near 1.72% in late October. The BOJ's balance sheet is still expanding, a metric that indicates monetary policy is still easing. There appears to be little chance that Japanese monetary policy will be altered soon. 

Without an improvement in the outlook for world growth, emerging markets as an asset class performed well in November. This may be linked to the softer US rate profile and the pullback in the dollar. The MSCI Emerging Markets Index rose by 14.6% in November to pare the year's loss to 21%. The MSCI World Developed Market Index rose by about 6.8% in November and narrowed the year-to-date loss to 15.8%. The premium paid by emerging markets over Treasuries fell by over 30 bp last month, and to around 388 bp is the lowest since June (using the JP Morgan Emerging Market Bond Index). The JP Morgan Emerging Market Currency Index rose 2.9% in November, its largest gain since March, leaving it down about 4.4% for the year.