Taking Stock: Contrasting interest rate outlooks hit sterling

The Fed and the Bank of England have raised interest rates by 75bps this week. Both show the markets that they are tough on inflation and have learnt from recent errors.

But they offered contrasting outlooks. The Fed promised ‘higher, for longer’, raising its target rate to 3.75% -4%. But the Bank of England believes its interest rate cycle may be close to peaking at the new 3% rate because of a ‘very challenging’ two-year recession -that has probably begun.

It will create the unemployment that both central banks see as key to reducing pay rises and, by extension, core inflation. In the US, the stronger underlying economy means it will take more rate hikes to achieve the desired increase in unemployment.
Sterling fell in response to the prospect of widening interest rate differentials and the poor outlook for UK growth. While US Treasury yields rose a little, UK gilts were largely unmoved.

Implications for the markets

In both countries, the housing market appears increasingly vulnerable, as the increased cost of capital hurts developers of building projects, and as higher mortgage rates reduces demand from purchases. Indeed, over-borrowed developers, property-holding companies, and owners represent an Achilles heel to the banking system and the broader economies because of the risk of falling collateral values and negative equity.

In the UK, the Nationwide building society told a House of Commons select today that it has a worst-case scenario of a 30% drop in house values arising from higher mortgage costs and an increase in unemployment.

The good news for US and UK investors is that the central bank’s enthusiasm for rate hiking will probably contain long-dated yields since the risk of recession has increased. We may be approaching, or even at, the peak in yields of the 10-year plus part of the Treasury and gilt curves.

This suggests opportunities over the coming months for fixed-income investors, assuming the monetary policies of the central banks this year do start to impact labour markets and, by extension, core inflation.

The bad news for investors is that the increased risk of recession in both countries, as short-term rates continue to rise in line with central bank policy, is bad for risk assets. More corporate earnings downgrades will come, reflecting weaker business and consumer demand and the increased cost of capital.

Companies that are dependent on economic growth and cheap capital (i.e., so-called growth stocks, such as tech stocks) look particularly vulnerable.
Investors in balanced multi-asset funds should sit still. There will be a time when interest rates start to fall and economic growth recovers. We do not know when it will be, but we do know from financial history the cost to portfolios of being ‘out of the market’, i.e., in cash, when sentiment does improve.

Translating the Fed

Central banks often give nuanced messages, so they are not hemmed into any one course of action as economic data unfolds. At other times, they like to appear determined and committed to a certain path to encourage investors and the real economy to respond in a way that will help them achieve their goals.

The Fed delivered a convoluted message on Wednesday, which is perhaps best seen as an attempt to do both at the same time: it wants to show sensitivity to the impact on the US economy of interest rate hikes so far in the cycle while also expressing a determination to bear down on inflation and create conditions for it to return to the 2% target rate.

Hence Chair Jay Powell’s promise to reduce the pace of future rate hikes while warning that the terminal rate may be higher than the approximate 5% that the market expects and reached later than this December.

In other words, the Fed is warning of ‘higher, for longer’ interest rates while trying to address fears that it is insensitive to any weakening of leading economic indicators.

QT: the Bank of England is getting away with it

A less-noticed aspect of UK monetary policy is the Bank of England’s successful auction of £750m of gilts earlier this week. This represents the first major central bank to engage in Quantitative Tightening (QT), which is the selling of bonds back into the market to reduce its balance sheet and reduce liquidity in the financial markets.

The gilts were acquired under the various Quantitative Easing (QE) programs of the last 14 years that led to a ballooning of the Bank’s balance sheet to approximately £900bn.

Other central banks, notably the Fed, have allowed their balance sheets to shrink by not re-investing the coupons earned on their bold holdings or the capital received from maturing bonds. Actual sales of bonds take the Bank of England into uncharted waters.

So far, so good, and demand for the gilts has held up. Investors have been reassured by the tough talk on fiscal policy coming from the UK government as we wait for the announcement on November 17 on how approximately £40bn of tax hikes and public spending cuts will be found.

Weak sterling and the strong dollar to persist, possibly with consequences

If the Fed’s rate tightening cycle is to outlast that of the Bank of England, which seems likely, the sterling will weaken further. The Bank of England may choose to intervene, given the inflationary impact of a weak pound on dollar-priced imports, or it may take the view that Britain is a poorer country now (post-Brexit, post-Covid), and that sterling must be allowed to find a new long term rate.

The strong dollar is as much a headache for the Fed. It helpfully reduces imported inflation but is hurting exports and may soon become a political issue—the lightning rod, perhaps, for a broader attack on Fed policy. The risk of this was highlighted recently by several Democrat Congressmen, who wrote to the Fed, warning that its monetary policy risks recession.

Having been dull for most of the last decade, monetary policy is again interesting!


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