Banks tightened and the market rallied: what’s going on?
Corporates | Kennett Square, PA
The European Central Bank (ECB), Bank of England (BoE), and U.S. Federal Reserve (Fed) all raised their respective benchmark rates last week. The ECB raised rates by 50 basis points to a key rate of 2.5% on Thursday and signaled another 50-basis-point hike was coming at the next meeting in March. The BoE also raised rates by 50 basis points to a key rate of 4.0% and suggested more would be needed. Finally, the Fed raised rates 25 basis points to a range of 4.5% to 4.75% and suggested more rate hikes would be necessary in the coming months. Despite the hikes, investors around the world latched onto the specific language used by central bankers and developed a risk-on sentiment.
The ECB noted that the economy slowed, but outperformed expectations for the last quarter. The ECB president, Christine Lagarde, explained supply bottlenecks were easing, firms still had large backorders, confidence was improving, and declining energy prices were helping to ease inflation and boost consumption. Although inflation persisted, Lagarde went on to say, “The risks to the inflation outlook have also become more balanced, especially in the near term.”
Although inflation remained high, the bank stated it had likely peaked within the U.K. and expected it to fall to 4% by the end of the year. Bank models suggested a terminal rate of 4.5% for the central bank, which would represent an additional 50 basis points from the current level by mid-2023. The same model suggested the rate would fall to 3.25% within three years.
In Chair Powell’s press conference, he noted the U.S. economy was slowing, but still expanding at a subdued pace. The main outlier in the overall economic slowdown, according to Powell, was the job market, which remained historically very strong. Although inflation was beginning to slow, Powell stated additional rate hikes would be necessary to bring inflation down to the Fed’s 2% mandate. Despite higher rates, Powell expects GDP growth will continue and a soft landing is achievable.
Powell mentioned the concept of disinflation at least 11 times during his question-and-answer session. He explained inflation was still occurring but decreasing overall as consumers shifted spending back toward services and supply chain pressures eased for many goods. Notably, he stated, “We expect inflation to continue moving up for a while but then to come down assuming that new leases continue to be lower.” Despite that, he also noted that the risks of not raising rates high enough and holding them there until inflation definitively starts to ease still outweigh the risks high rates may have on the broader economy. In other words, the FOMC is not expecting to cut rates until at least 2024.
Toward the end of his press conference, Powell explained why the FOMC forecast of rates differs from that of the market. He explained that the FOMC sees inflation decreasing slowly over time, which warrants a higher fed funds rate for a longer period. Other forecasts (the market) expect inflation to decline much more quickly, which is why, in Powell’s view, some individuals see rate cuts occurring this year. Powell went on to say that if inflation does indeed come down much more quickly than the FOMC predicts, it will incorporate that into its new policy stance.
Every central bank release stated, in one way or another, that policymakers would continue to monitor market conditions and base their decisions on relevant data. To Powell’s point, right now the broader market seems to be pricing in inflation returning to 2% quickly in combination with continued GDP growth. After the central bank releases, the market seemed to latch onto the positive notes by central bankers and generally ignored the potential upside risks to inflation or declining GDP growth. As a result, interest rates fell across the board on Wednesday. Swap rates fell, cap premiums declined, and the U.S. dollar index fell to its lowest level since April 21, 2022.
The goldilocks scenario of a soft landing is arguably already priced into the market. This means risk-off sentiment would likely occur if any negative news disrupted that view. That happened on Friday when the jobs report stated 517,000 jobs were added in February and unemployment hit its lowest level since 1969 at 3.4%. The strong labor report suggested the Fed’s view of sustained inflation and higher rates for a longer period is still a very real possibility. On the news, rates jumped, and equities sold off. By Monday, February 6, the 10-year treasury rate hit its highest level in nearly a month, completely reversing the market's optimism from last week.
It is best practice for corporations to model the impacts of the various narratives and understand the risk implications to their business models. If the Fed’s narrative plays out, the costs of hedging will presumably increase over the next year as the market re-adjusts its expectations to align with the Fed. On the other hand, if the market’s narrative prevails or if inflation falls even more rapidly than the market is already pricing in, for instance, due to a potential recession, corporates will benefit by holding off on hedging and waiting for interest rates to fall even further.
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