Last Friday, after the latest inflation US data, everything seemed clear already: Higher-than-expected inflation in May would lead the Federal Reserve to continue raising policy rates quickly. Signals from the ECB that it, too, was ready to act and bond and equity markets swooned.
The Fed and inflation
The US headline consumer price index in May rose by 1.0% versus the prior month and 8.6% from a year go, surprising to the upside and challenging the assumption that the inflation peak was behind us. That view now looks like wishful thinking.
While the core index (ex food and energy) continued to slow from 6.5% in March to 6.2% in April and 6.0% in May, other measures of underlying inflation rose, suggesting that inflationary pressures are broad-based, particularly in the services sector (airfares, hotel rooms).
In addition, the cost of shelter, as measured by rents and owner-equivalent rents, rose sharply. Goods inflation accelerated mainly due to car prices (new and used).
As a result, and as was widely expected after media reporting on Monday, the Fed raised rates by 75bp at its latest policy meeting, marking its largest move in 28 years.
The main new piece of information from chair Jerome Powell’s news conference was that the decision at the next meeting would be between either a 50bp or 75bp rate rise. Powell described the Fed’s larger hike in response to the inflation data as unusual. That should help damp down (at least for now) market speculation about the possibility of a 100bp increase at the July policy meeting.
The Fed also published new economic forecasts. These continue to show a benign outlook. The latest interest rate ‘dot plot’ shows rates hitting almost 3.5% at the end of this year, moving up another 50bp in 2023 before modest easing begins in 2024.
Market expectations ahead of the latest Fed action had already sent the 10 year T-note yield to 3.47% at the close on June 14, marking a level not seen for a decade and causing a flattening of the yield curve, with the 2-year yield closing at 3.43%.
The assumption of a sharp tightening of US monetary policy has weighed heavily on equity markets. The S&P 500 recorded falls for five days in a row, losing 10% between 7 and 14 June.
The ECB and fragmentation
On the other side of the Atlantic, equities also fell sharply, although by slightly less (-8.2% for the EuroSTOXX index between 7 and 14 June).
In fixed income markets, the outlook is no brighter than in the US. Since the ECB meeting on 9 June, the 10-year Bund yield has risen by more than 40bp to close at 1.76% on 14 June, marking its highest point since early 2014.
Moreover, spreads within the eurozone widened abruptly, resurrecting the spectre of a sovereign debt crisis. The end of net asset purchases by the ECB raised concerns (arguably somewhat premature) that more indebted countries would have difficulty financing their debt in the face of rising borrowing costs.
Eurozone ‘peripheral’ bond markets have suffered. At the close of 14 June, the spread between Italian and German yields exceeded 240bp on 10-year maturities compared to 200 bp at the end of May. The crossing of the 200bp threshold, later 225bp and finally 250bp intraday, aroused nervousness among market participants who thought the ECB would not tolerate such a surge in Italian yields and would react accordingly.
Indeed, it did. The reaction was a two-act play: Isabel Schnabel, member of the Executive Board, indicated that the ECB would not tolerate fragmentation that would impair monetary policy. Despite her strong words: ‘Our commitment to the euro is our anti-fragmentation tool. This commitment has no limits’, the speech did not appear to fully convince investors.
This was followed by an ad-hoc meeting of the Governing Council to ‘discuss current market conditions’. The ECB announced that it ‘will apply flexibility in reinvesting redemptions coming due in the Pandemic Emergency Purchase Programme (PEPP) portfolio, with a view to preserving the functioning of the monetary policy transmission mechanism’. In addition, work on the design of a new anti-fragmentation instrument would be accelerated.
The ad-hoc meeting had the merit of making it clear that the ECB was concerned about the sharp swings of spreads in the eurozone and wanted to put its flexibility and anti-fragmentation view on record, signalling that it could act during erratic market movements.
If the effect is not (yet?) as impressive as former President Mario Draghi’s July 2012 comment (‘the ECB is ready to do whatever it takes to preserve the euro’), spreads have now tightened and it is likely that many investors have to unwind their short positions (a crowded trade) not only in ‘peripheral markets’, but also in ‘core’ markets such as Germany.
Our fixed income management teams have decided to move their exposure to Italy back to neutral from underweight while keeping their short duration in multi-asset portfolios.
As central banks exit, more or less gradually, from the exceptional monetary policies put in place during the pandemic, they are showing that they remain attentive to the market’s reaction. The fight against inflation has become the key variable in their reaction function, but they have no desire to provoke a new crisis.