With no respite in inflationary pressures, bond yields are rising significantly as investors position for a substantial ratcheting-up of policy rates by both the ECB and US Federal Reserve later in September.
Jackson Hole – A hawkish message
At last week’s annual gathering of central bankers and economists in Jackson Hole, Wyoming, Fed Chair Jerome Powell did not mince his words, delivering a hawkish speech specifying the Federal Open Market Committee’s (FOMC) ‘overarching focus of bringing inflation back down to the 2% goal’ and the importance of price stability as the bedrock of the US economy.
Having quashed hopes that the Federal Reserve would step back from its tightening of monetary policy anytime soon, Chair Powell reaffirmed his ‘unconditional’ commitment to tackling high inflation and made it clear that restoring price stability would probably require maintaining a restrictive policy stance for some time.
This would appear to be aimed at countering the market’s expectation of rate cuts relatively early in 2023.
The Fed Chair acknowledged that restoring price stability was likely to ‘require a sustained period of below-trend growth’ with very probably ‘some softening of labour market conditions.’
Powell noted that the current target range for the federal funds rate of 2.25-2.50% is the level at which the Fed projects the rate to settle in the longer run (i.e. the neutral rate). He then pointed out that in current circumstances, with inflation running far above 2% and the labour market extremely tight, estimates of the longer-run neutral rate were ‘not a place to stop or pause.’
The next FOMC meeting takes place on 20-21 September and Powell did not rule out a third consecutive 75bp increase in the fed funds range. The Fed’s decision at the September meeting will depend on the totality of the incoming economic data with US jobs data due out on 2 September delivering fresh information on conditions in the labour market. Consensus forecasts expect US employers to have added 300 000 new jobs in August, down from 528 000 in July.
Our macro research team forecasts that US core PCE inflation will decline to 3.9% only a year from now, factoring in rate rises that will take the federal funds rate to 4.00%-4.25% in the first quarter of 2023.
Market reaction to Powell’s speech
In the wake of the hawkish messaging from Jackson Hole, US stocks posted four straight days of declines. This resulted in a fall of almost 6% for the S&P 500 and just under 7% for the NASDAQ composite, taking the shine off the rally over the summer (see Exhibit 1).
Yields of US government bonds have risen in the wake of Powell’s speech. The yield on the two-year Treasury note has reached 3.5% this week, its highest since 2007, while the yield on the 10-year US Treasury note has risen to 3.2 %.
ECB meets on 8 September
Europe’s bond markets had a difficult August with eurozone debt hit by heavy selling after July’s rally. Performance suffered as investors positioned themselves for more aggressive central bank monetary policy to counter surging food and fuel prices triggered by Russia’s war in Ukraine.
The sell-off was fuelled further this week after data showed the rate of consumer price growth in the euro area hit a record 9.1% in August. The 10-year German Bund yield rose by just over 0.7% in August to trade at 1.54 %. This is the single largest monthly rise since 1990. Meanwhile, the 2-year Bund yield also registered a significant rise, ending the month at 1.1%.
August saw another strong rise in European gas prices. Futures linked to the wholesale gas contract TTF rose by nearly 40%, taking the rise over the last two months to almost 70%. This week, Russia again halted gas exports to Europe through the Nord Stream 1 pipeline, saying maintenance work was necessary until 3 September.
The US dollar rose for a third consecutive month against the euro. The euro depreciated by 7.4% against the dollar. The minutes of the ECB’s policy meeting in July specifically referred to the euro’s fall as an important change in the external environment implying greater inflationary pressures via higher costs of energy imports invoiced in US dollars.
All told, this environment puts pressure on the European Central Bank to accelerate the pace of interest rate rises. In July, the ECB raised its deposit rate, for the first time in a decade, from minus 0.5% to zero. Markets are now pricing in the possibility of a 0.75 percentage point increase at its meeting on 8 September.