Investors pay heed to the decisions of the Bank of Canada (BoC) as a ‘leading indicator’ of monetary policy elsewhere. The BoC’s recent interest rate increase of just 50bp, when expectations were for a 75bp move, generated a wave of commentary. The European Central Bank, on the other hand, met expectations and raised its three key rates by 75bp.
The revenge of the Fed pivot
For several weeks now, investors have been focusing on any information that might suggest the US Federal Reserve (Fed) would soon swivel away from its aggressive tightening cycle.
Last Friday’s publication of a Wall Street Journal (WSJ) article by an editor reckoned to be well informed of the Fed’s intentions re-invigorated the idea of a ‘pivot’ in US monetary policy.
While another 75bp rate rise, taking the upper end of the federal funds target rate to 4.00% on 2 November, is now fully anticipated, the article mentioned that, despite September’s high inflation number, Federal Open Market Committee (FOMC) policymakers were likely to debate whether and how to signal plans to approve a smaller rate rise in December.
As market estimates for the peak rate of the tightening cycle had exceeded 5.00% a few days before, this article led to a sharp fall in front-end rates on the US yield curve.
The correction seemed justified by disappointing economic indicators. The smaller-than-expected rate rise in neighbouring Canada provided further sustenance to the notion that the Fed may slow its pace of tightening. The US 2-year yield, which had exceeded 4.6% just before the WSJ article, slipped to 4.4% on Wednesday, while the yield on the 10-year T-note was at 4.0%.
Last Friday’s WSJ article indicated the Fed faced a balancing act between over- and under-tightening, highlighting a reference in the minutes of the FOMC’s policy meeting of 20 and 21 September to the need to ‘calibrate’ the pace of additional policy rate increases.
The overall tone of these minutes was on the other hand definitely hawkish: They indicated that the cost of taking too little action to bring down inflation likely outweighed the cost of taking too much action. The fight against inflation would have to be maintained even as the labour market slowed.
In a nutshell: we believe markets should not confuse Tapering the pace of rate hikes and Pivoting monetary policy.
Across the pond
The ECB, meanwhile, stayed the course with a further 75bp rate rise, marking its third major increase in a row.
It described the move as evidence of “substantial progress in withdrawing monetary policy accommodation” and signalled more was to come “to ensure the timely return of inflation to its 2% medium-term inflation target” and to guard against a ‘persistent’ upward shift in inflation expectations.
To reinforce the transmission of higher policy rates to bank lending conditions, the ECB decided to raise the rate on its targeted longer-term refinancing operations (TLTRO III) and offer banks additional voluntary early repayment dates.
According to the preliminary estimate of PMIs (purchasing managers’ survey data), the fourth quarter did not start under the best possible auspices. The indices dropped significantly (with the notable exception of Japan).
In the eurozone, the composite PMI fell to 47.1, an almost two-year low, due to a sharp decline in manufacturing activity. The composite index held below the growth/contraction threshold at 50 for the fourth consecutive month. October’s level corresponds to a moderate contraction in GDP.
The deterioration in PMIs was manifest for the German manufacturing sector (from 47.8 to 45.7, marking its lowest in 28 months). Uncertainty and increased financial constraints weighed on demand.
UK indices fell to a 29-month low in the manufacturing sector (at 45.8) and a 21-month in the services sector (at 47.2) as companies faced the biggest drop in demand since January 2021 amid rising prices and a confused political situation, culminating in the resignation of Liz Truss as prime minister.
Finally, in the US, PMI business and household surveys came in below expectations, with the index falling below 50 in the manufacturing sector. Regional Fed manufacturing business surveys and consumer confidence data also disappointed.
Over-interpreting weak signals?
This poor economic data has fuelled the notion that aggressive monetary tightening will soon have to be called into question, especially in the US where the rise in mortgage rates is beginning to weigh on the housing market.
The Bank of Canada noted that “higher mortgage rates have contributed to a sharp slowing in housing activity from unsustainable levels, and consumer and business spending on goods is moderating.” However, the BoC still expects that its policy rate will need to rise further.
Its rhetoric echoed that of the Reserve Bank of Australia at the beginning of the month after it increased its policy rate by a (modest) 25bp. It is worth noting, however, that the BoC governor also signalled that he was ‘trying to balance the risks of under- and over-tightening’.
Consequences for our portfolios
In addition to the movements in US government bonds referred to above, the adjusted expectations of the Fed’s monetary policy course were accompanied by a slight ebb in the US dollar on the foreign exchange markets (see Exhibit 1).
This is good news, for, among others, the Bank of Japan. It has had to make further direct intervention in the markets in recent days to curb the depreciation of the yen.
The fall in long-term bond yields has been widespread, probably amplified in Europe by the changes in the UK government. Although details of its fiscal plans will be unveiled only in mid-November, investors now hope to see a more sustainable path for UK public finances in view of the first spending cuts and tax increases announced by Finance Minister Jeremy Hunt.
Global equities benefited from the talked-about ‘pivot ‘scenario: The MSCI AC World index gained 3.7% in US dollar terms between 20 and 26 October. US equities outperformed, with the S&P 500 index (+4.5%) supported by gains in growth stocks and earnings surprises from the current reporting season.
We believe this trend could last and we now consider it appropriate to rotate our overweight in Japanese equities to US equities, especially technology stocks. Although the Fed’s pivot does not look imminent, expectations for the peak policy rate should have themselves peaked.
Apart from Japanese equities, we are cautious on eurozone equities. We have increased our exposure, however, to eurozone investment-grade (IG) credit.