As the last two major meetings of the world’s central banks approached this week with the Federal Reserve and the Bank of England (BoE), an air of complicity floated through the markets – led first by the Bank of Canada, which delivered a lower-than-expected 50 basis point (bp) rate hike on Oct. 26. This was followed by the European Central Bank the next day, where policymakers made a second hike of 75 basis points, but signaled a reluctance to explicitly state that further hikes are on the way, while raising doubts about the need to raise policy rates well beyond the “neutral” level and into economically restrictive territory, despite continuing high inflationary pressures.
And that set the stage for the final Fed meeting this week where markets expected the Fed to follow suit with a long-awaited dovish pivot away from giant rate hikes. In fact, it went largely in line with consensus expectations – with the meeting confirming that after a fourth consecutive 75 basis point rate hike, the pace would likely slow “by the next meeting” in December, according to the Fed Chairman Jerome Powell during his press conference. conference. But moments later, he again suppressed any sense that the Fed was ready to give up on its fight against inflation.
After an initial positive market response to the policy statement, something Powell apparently caught wind of as he continued to deliver some of his most hawkish statements, sending stock indexes falling sharply and Treasury yields rising.
Of particular note is that while the pace of increases may well slow, the level of rates ultimately needed may be “higher than previously thought”, a level estimated at 4.75% as recently as the meeting. of the Fed’s mid-September. Powell cited recent labor market and inflation data that has yet to show any real signs that the 375 basis points of total policy tightening over the past nine months – the most on a window similar since 1980 – have in fact had a very significant impact. . As the chart shows, the process of finding out how far rates need to go has been a process indeed – from a record high of 2.75% at the March meeting, 3.75% in June and 4.75% in September. It seems to us that the Fed still does not have a clear idea of what this terminal level is, and that is only adding uncertainty and volatility to US markets.
Fed expectations for final interest rate stance continue to rise
Line chart illustrating that the Fed’s expected maximum interest rate level for this cycle has continued to rise over the year, from just 2.75% at the March FOMC meeting to 4.75% when the Fed last provided updated economic projections. Fed Chairman Powell has signaled that this level could be even higher now, forcing RBC Capital Markets to raise its terminal rate to 5.25% by March 2023.
Federal funds rate
RBC Capital Markets forecasts
Fed Terminal Rate Projection
Source – RBC Wealth Management, Bloomberg, RBC Capital Markets, Federal Reserve Summary of Economic Projections
So, in the wake of the Fed digging its heels in and offering little reason to doubt its resolve, RBC Capital Markets raised its peak policy rate forecast to 5.25% from 4.75%, which it expects to reach by March 2023 via a series of 50, 50 and 25 basis point rate hikes in December, February and March, respectively.
Higher for shorter
So far, the general sense has been that the Fed would raise rates high – but perhaps not excessively high – and then leave them there for an extended period while a hoped-for “soft landing” occurs. . But in our view, the risk only grows that the Fed will just keep going until something breaks, and that higher rates mean a quicker policy reversal as prospects for a “hard landing” » of the economy increase. As the saying goes, the bigger they are, the harder they fall.
And the Fed seems… okay with that? Also according to Powell’s press conference, he clearly remains in the camp that considers the risks of doing too little to outweigh the risks of doing too much, stating “…if we were to overtighten, we could then strongly use our tools to support the economy. Whereas, if we’re not getting inflation under control because we’re not tightening enough, we’re now in a situation where inflation is now entrenched…” This basically means that if the Fed gets it wrong, it could just start cutting rates. .
A story of two countries
While the Fed continues to be unwilling to give the markets even an inch by warning that rates could rise higher than expected, the BoE has taken a different approach by stating that if key rates do indeed rise that high than markets predicted – north of five percent in 2023 – a two-year recession could be the result.
So while the BoE carried out a 75 basis point rate hike, the biggest in over 30 years, firmly pushing the market back, it set a decidedly dovish tone, with the pound falling almost 2% against the dollar following its meeting. This puts the strength of the dollar – which has previously caused global tensions – back on the radar as the Fed is now isolated.
Narrow seas, wide opportunities
Although Powell noted that the path to an economic soft landing is “narrowing,” we believe the opportunities for bond investors following aggressive central bank rate hikes have only widened. As the chart shows, global investment grade bond index yields around the world are approaching multi-decade highs. But as Powell also noted, the Fed could be forced to backtrack as quickly as it had anticipated, which means the window for investors to get silver working at historically attractive levels could also close sooner than some think.
Tighter global central banks have pushed bond yields back to near 20-year highs
Line chart showing that global central banks acted aggressively in 2022 to raise short-term policy rates, the yield offered by global investment grade global bond indices is approaching some of the highest levels of the past decade, such as the Bloomberg US Treasury Aggregate Index maintaining a return of 4.4%, the US Aggregate Bond Index a return of 5.0% and the Global Aggregate Ex-US Bond Index a return of 2.7%.
Bloomberg US Treasury Aggregate Index Return
U.S. Global Bond Index Return
Return of the Global Aggregate ex-US Bond Index
Source – RBC Wealth Management, Bloomberg Bond Indices
In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc., which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are offered by RBC Dominion Securities Inc.
Fixed Income Strategies
Portfolio Advisory Group – United States