Market skittishness complicates central banks’ interest rate plans

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Skittish financial markets are stuck in an “endless loop” as traders’ reactions to comments from central bankers make it more complicated for those policymakers in their battle with inflation, say analysts and fund managers.

In recent months central bankers have signalled that the series of aggressive interest rate rises to curb price pressures may shortly be over. That would bring an end to policies that have seen benchmark lending rates in the US and Europe hit their highest levels in more than a decade.

But as the cycle of rate rises draws to a close, policymakers are finding that firmer guidance for the market is creating a Catch 22 situation.

Any indication that rates will start falling has triggered a rally in bond prices, pushing yields lower. This lowers borrowing costs, which in turn can ease the tight financial conditions that central bankers have been trying to create in order to bring inflation back to target.

That puts the onus back on to policymakers to consider extended higher rates, investors and analysts say.

Markets now find themselves in “an endless loop where everyone is frustrated”, said Dario Perkins, head of global macro at research firm TS Lombard. “I guess we just bump around until we get some clarity on whether it’s a hard or soft landing [for the US economy].”

Central bankers and markets have found themselves in such a loop in recent weeks.

In quick succession, the US Federal Reserve, the Bank of England and the European Central Bank kept borrowing costs on hold.

The Federal Reserve’s move in particular helped fuel sharp market rallies on both sides of the Atlantic. Treasury yields suffered their biggest weekly decline since the collapse of Silicon Valley Bank in March last week, while Wall Street’s S&P 500 stocks index rose for eight consecutive sessions from October 27, its best run in a year.

Those moves were the equivalent of a 0.5 percentage point interest rate cut, according to Goldman Sachs analysts. An index of US financial conditions — a proxy for market conditions that determine borrowing costs for companies — eased to the lowest level since April 2022 for the week ending November 3, according to an index compiled by the Chicago Federal Reserve.

After the ECB left rates at 4 per cent, president Christine Lagarde stressed that it was “totally premature” to consider rate cuts. Nonetheless markets are pricing in more than 0.8 percentage point of cuts by the end of 2024.

“This seems to be a bit excessive and we are now facing a co-ordinated effort by ECB policymakers to push against those market-implied rate cuts,” said Christian Kopf, head of fixed income at Union Investment.

The ECB is not alone. Andrew Bailey, governor of the Bank of England, warned on Wednesday it was “too early” to think about rate cuts, days after his chief economist Huw Pill suggested it was reasonable for markets to expect rates to fall from the middle of next year.

Fed chair Jay Powell on Thursday told markets not to be “misled” by good data on prices, sparking a sell off in bond markets that pushed up 10-year Treasury yields by 0.08 percentage points this week. German Bund yields, the eurozone benchmark, have risen 0.1 percentage point since Monday.

Some analysts say that Powell’s hawkish comments suggest the Fed would prefer to tighten financial conditions through higher Treasury yields rather than through further rate increases. 

But this creates a dilemma for the Fed, because any signal that higher yields are doing the job of bringing down inflation could prompt investors to buy bonds in anticipation of lower rates. This fall in yields then negates what the central bank was trying to achieve.

“Buying bonds in anticipation of the Fed ending its tightening cycle because high bond yields have done the tightening for it is a self-defeating strategy,” said Benjamin Picton, senior macro strategist at Rabobank.

While the market and central bankers try to second guess each other, falling yields may begin to ease the credit conditions for companies that have been tightened by higher interest rates.

Before Thursday’s sell-off, the rapid decline in benchmark yields had helped to pull down borrowing costs for risky US companies. The average yield on US junk bonds now sits at roughly 9 per cent, according to Ice BofA index data, down from more than 9.5 per cent just three weeks ago.

Some investors worry that central banks want to see further evidence of the impact of sustained rate rises before declaring the tightening cycle is over, particularly as it takes several months to feed through to their economies.

Compounding the problem for policymakers, market sentiment and underlying lending conditions can diverge. The Fed’s latest Senior Loan Officer Opinion Survey showed that “significant net shares of banks reported having tightened standards on [commercial and industrial] loans to firms of all sizes” over the third quarter of 2023.

Next week’s inflation data in the US and the UK will give the latest indication of the extent to which tighter policy is starting to feed through.

Mark Dowding, chief investment officer at BlueBay fixed income, said the US reading could be stronger than the market expects. “We continue to operate in an environment of macro uncertainty, and it feels that there is plenty still in play before 2023 is done,” he said.

But as inflation numbers decline, conviction that interest rates have peaked is only likely to grow, encouraging the market to anticipate interest rate cuts — making it more difficult for central bankers to be taken at their word.

The recent “risk-on environment” in markets and the corresponding easing of financial conditions “is not a good thing from the Fed’s perspective, which is why I think we got that hawkish Powell language [on Thursday] around the fact that the Fed’s not convinced it has nipped inflation in the bud”, said Kristina Hooper, chief global market strategist at Invesco.

“We’re going to get more hawkish Fed speak. But . . . it’s very performative,” Hooper added.

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