A week ago, the US Federal Reserve (Fed) surprised markets with a hawkish tone despite keeping the federal funds target rate at 0% to 0.25% – a range that has been in effect since March 2020 – and leaving the pace of asset purchases at USD 120 billion a month.
After its latest policy meeting, it reiterated that until ‘substantial additional progress has been made towards the full employment and price stability targets’, policy was on hold.
Policy tightening: Soon, sooner… later?
Without highlighting this, its message did signal that change was coming. The Fed sketched an upbeat scenario on employment and its ‘dot plot’ showed interest rates might rise by end 2023. This led investors to consider that the lift-off in rates could be earlier than thought.
Two days later, St. Louis Federal Reserve President James Bullard said that he expected the Fed to raise its key rate even earlier, in 2022, given his forecast for above-target inflation.
Just yesterday, at his testimony before Congress, chair Jerome Powell tried to tone down this perception. He reiterated he saw the inflationary pressures as transitory, that monetary policy aimed for a complete and inclusive recovery in employment, and that the Fed would not raise rates pre-emptively. He appears to have succeeded.
Were investors and economists lost in translation?
Unsurprisingly, financial markets were rattled. The yield on the 10-year US T-note moved between 1.35% and almost 1.60% to finish at 1.46% on 22 June (see exhibit 1). US equities sagged after the initial analysis of the Fed’s conclusions, but have managed to return to last week’s level. The S&P 500 lost 1.9% between 11 and 18 June, marking its largest weekly decline since February.
What are investors to make of the back and forth? Was it a communication error by the Fed? A test balloon? Over-interpretation? Whatever the explanation, recent developments clearly reflect nervousness.
While chair Powell said at his 16 June press conference that discussions on reducing the pace of asset purchases (tapering) had begun, paradoxically, that did not spark a ‘taper tantrum’.
Has the economic environment changed?
Not really, in our view. Purchasing managers surveys (PMI) showed activity continued to recover in June in the eurozone manufacturing sector, but even more so in services. According to the flash estimate, the composite PMI hit a 15-year high. The survey points to a lengthening of supply chains and strength in order books, leading companies to hire extra staff.
The figures confirm European economies are catching up thanks to the progress on vaccinations. This is making it possible to phase out health restrictions. The US is ahead, both on vaccinations (with 45% of the population fully vaccinated, compared with 25-30% in large eurozone countries) and when it comes to the economic recovery. US GDP grew at an annualised 6.4% in Q1. Data points to growth of about 10% in Q2.
The most recent indicators, particularly on the US housing market, have shown a slight decline in activity, but this does not call into question the strength in domestic demand. Summer holidays should be an opportunity for US households to spend some of their savings as the employment outlook is good.
The scenario of a synchronised economic recovery in the second half of the year remains valid.
So why worry?
Perhaps because it is natural or perhaps because global equities are up by 10.6% so far this year and 26% higher from end-2019 (as of June 22), interest rates are below fair value calculated on a nominal growth basis, and real rates are still largely negative.
The recent volatility is also a sign of the difficulty investors and central bankers alike face in moving from a health and economic emergency to a return to (a form of) normalcy.
Both the Fed and the ECB do not seem to want to jump the gun and have indicated that they intend to ensure financial conditions remain favourable. ECB President Christine Lagarde recently reiterated before the European Parliament that despite the prospect of a stronger recovery, the time had not yet come to raise interest rates.
Central bankers: More speaking in tongues?
How monetary policy intentions are communicated will be crucial in the coming months. As we have just seen with the Fed, this will not be an easy exercise.
The next two monetary policy meetings – on 22 July for the ECB and 28 July for the Fed – are not deemed critical by investors.
However, the 26 to 28 August Jackson Hole symposium and the 28 and 29 September Sintra meeting may provide the two leading central banks with an opportunity to clarify their medium-term approaches to policy, while the scars of the pandemic on potential growth will still be visible for several years.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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