With no prospect of a let-up in the tightening of monetary policy on either side of the Atlantic, equity and bond markets have remained volatile. The extent of the back-up in real interest rates has been such that they are now at levels that may be attractive for investors taking a longer-term view.
The latest US economic data – including the September jobs report and in particular the latest consumer price inflation (CPI) numbers – have done nothing to suggest the US Federal Reserve will deviate from its objective of raising policy rates to a restrictive level rapidly.
Not only did core US inflation (ex-food and energy) exceed expectations at +0.6% in September, but a confluence of inflationary developments – including concerns among Fed officials over wage-price feedback loops, renewed supply chain disruptions and OPEC+ oil production cuts – are likely to reinforce hawkish sentiment among policymakers and encourage them to maintain the speed of the current hiking cycle at full tilt.
Moreover, the most recent University of Michigan and New York Fed data showed an uptick in inflation expectations. Any hint of an unmooring of inflation expectations will likely keep the Fed on an aggressive tightening path.
Playing catch-up in Europe too
It looks as if the European Central Bank (ECB) governing council is converging towards raising policy rates by 75bp at its meeting on 27 October. Our macroeconomic team expect a further rise of 75bp in December as well.
A decision by the ECB on elements of the operational framework is also likely next week. Our bias is for a change directly targeting the ultra-cheap loans made by the ECB under its targeted longer-term refinancing operations (TLTRO), rather than a more conventional tiering mechanism.
We expect no decisions as yet on quantitative tightening (QT), but the press conference after the meeting may reveal more about the council’s envisaged timetable.
The ECB, like the Fed, is now seeking to take policy rates into restrictive territory, or beyond the 2% level which most members likely agree is ‘neutral’. There may be calls to accelerate the QT timetable. Overall, we expect a 3% terminal rate to be reached in Q1 2023. It seems unlikely QT will commence before the ECB reaches the terminal level, although hawks may push for an earlier start.
The European Commission set forth its newest emergency proposals which will potentially be adopted at the European Union (EU) Summit on 20-21 October.
The proposals include:
- Developing a joint EU gas purchasing mechanism
- Creating default EU solidarity rules that extend beyond member states
- Constructing an alternative liquid natural gas (LNG) price benchmark by March 2023
- Introducing a dynamic price cap on the Dutch TTF (Title Transfer Facility) futures as a measure of last resort
- Reallocating EU Cohesion Policy Framework funds (up to EUR 40 billion) to member states.
No change in China’s Covid policy
The initial takeaways from China’s 20th Party Congress have been mixed and yielded few new positive surprises, with the leadership reaffirming the priority of economic development.
There has been little news on the zero-Covid policy front. This strategy — responding with lockdowns to any outbreaks in an attempt to stop the spread of the coronavirus – remains a critical issue for many investors.
Authorities in Beijing have this week dialled up measures to stop Covid, strengthening public checks and locking down residential compounds after a rise in cases in recent weeks. Any significant deterioration of the situation will weigh on sentiment both with regard to Chinese asset markets and the global economy.
No let-up in UK turmoil
UK assets continue to be under the spotlight after comments from the new chancellor of the exchequer suggesting a ‘whatever it takes’ approach to restoring market confidence. The pound has rallied with the chancellor’s U-turn on fiscal policy, but fundamental challenges linger.
The outlook remains bleak, policy credibility is depleted, political uncertainty remains high, the Bank of England’s bond purchase operations have ended, the central bank will likely continue raising rates into a sluggish economic environment, and the UK has a sizeable current account deficit to fund.
Still, the sentiment reversal has helped both duration and risky assets perform, at least for now.
Real yields near attractive levels
There has been a significant rise in US real yields (see Exhibit 1 below), to levels that may be attractive for investors taking a long-term view.
Our multi-asset portfolio management team are inclined to look at taking on some interest rate risk at these levels. While further rises in real interest rates cannot be excluded, the team believes they are now at a level that may constitute an entry opportunity.