We are seeing a pivot in central bank policy, notes Global Bonds Portfolio Manager Andrew Mulliner, following the BoE and ECB meetings on 3 February, as markets price in a policy error in the UK.
- At their meetings on 3 February, the Bank of England and European Central Bank delivered a more hawkish message, including that earlier action on interest rates was warranted.
- Market reaction was swift; with bond yields rising to levels last seen in 2018. In the eurozone, the underperformance of European periphery government debt versus core countries was notable.
- This is another occasion where we have been witnessing a sea change in central banks’ reactions in recent weeks, who recognise that they are now behind the curve. However, a significant degree of monetary tightening appears now to be priced, particularly at shorter maturities.
The first week of February was a busy time for central banks in Europe with two pivotal meetings for the Bank of England (BoE) and the European Central Bank (ECB).
What happened at the BoE meeting?
The BoE raised the bank rate by 25 basis points (bp) to 0.5%, the first consecutive rate increase since 2004. But it was a close call for more – with four out of the nine members of the Monetary Policy Committee (MPC) voting for a 50bp rise. The central bank also announced that the £20bn of sterling corporate bonds accumulated through the quantitative easing (QE) programme will be ‘sold down over the coming years (but not before the end of 2023)’. In addition, the reinvestment of the large stock of gilts held from this programme will also cease; the bank’s balance sheet will therefore begin to shrink as the gilts mature. Over the next four years, these maturities will reduce the balance sheet by around a third.
The BoE also released its latest monetary policy report outlining economic projections. The bank expects consumer price index (CPI) inflation in the UK to peak at 7.25% in the spring of this year; fall over the next two years, and be below its target of 2% in three years’ time. This is based on the interest rate profile priced by the market at the time (mid-January1), which implied 1.5% bank rate by June 2023. The market is now pricing a bank rate closer to 2% at time of writing. On an alternative assumption of keeping interest rates at 0.5%, the bank forecasts CPI inflation to be above its target, at 2.6% and 2.1% in two- and three-years’ time, respectively.
Additionally, it expects the unemployment rate to rise over the 3-year forecast period from 4.1% to 5.0%. Gross domestic product (GDP) growth over that period is projected to be not much more than 1%, partly reflecting the cost-of-living pressures on the consumer that are expected to bite.
What does it all mean?
In the UK, is it perhaps a case of ‘more now, and less later’? With four MPC members voting for a 50bp rate rise, the door for March and May interest rate hikes is firmly open. Even though prices take slightly longer to fall, inflation could be running below target a little over a year from now, particularly if energy prices follow the expected path implied by today’s forward curves2. The scope for lower energy costs is one reason to think market expectations for rates may well be too aggressive.
The market reaction has been to invert the government yield curve further3 – with the move being led by the rise in short-term yields. In other words, the market is pricing in a policy mistake; that some of the rate hikes will ultimately need to be unwound in the future. While that profile may make some intuitive sense, in our view it is much less likely to be realised in practice.
Market expectations for the bank rate in 2022
Source: Bloomberg, Janus Henderson Investors, as at 7 February 2022.
Note: Implied bank rate from overnight index swaps (OIS).
Looking at the range of potential interest rates scenarios and their expected profile, it appears to us that a series of hikes will likely occur over the coming quarters to take the bank rate to 1%. We believe the BoE will then probably pause to assess the impact and future options for the balance sheet, at which point inflation may well be moving back towards the target range.
What happened at the ECB meeting?
The ECB left policy rates and asset purchases (QE) unchanged as widely expected. However, the market‑moving news was the hawkish change in tone at the press conference from ECB President Lagarde, and the implications for future adjustments to asset purchases – and by extension, interest rates. With inflation surprising to the upside earlier last week (5.1% in January 2022) and the record low unemployment rate, it is clear the ECB are more concerned about inflationary pressures and second‑round effects. Lagarde refused to rule out a 2022 rate hike.
There was no change in guidance on policy sequencing (interest rate hikes versus ending asset purchases), so the asset purchases (under QE) will likely need to end ahead of the first rate hike. This paves the way for a significant reassessment of the pace of bond-buying programme at the next ECB meeting in March. This will coincide with revised forecasts on growth and inflation.
What does it all mean?
The markets’ reaction post the ECB has been to price in multiple interest rate hikes and a significant widening in the spreads4 of periphery government debt (particularly Italy and Greece) versus the core eurozone countries. Meanwhile, the German 5‑year government bond yield edged into positive territory in the sell‑off as the markets repriced their expectations.
Thus, while rate hikes from the ECB are on the table, it is around these policy shifts that price moves can become excessive as investor positioning is unwound. Concern on inflation in the ECB Governing Council is unanimous – the path of tightening is not. Market pricing and forecasts are well above what has been endorsed by even the more hawkish members of the governing council. Inflation, further out into the future, is still expected to fall and labour market measures, specifically wages, are front and centre in the ECB’s mind around more persistent inflation. We will not have much more clarity on wages until the second half of this year, owing to timings of major wage negotiations in the main eurozone economies.
The ECB is clearly concerned about being caught behind the curve; however, unlike the BoE and the US Federal Reserve, the ECB has to deliver policy for the whole of the eurozone. A significant challenge to potential tightening from the ECB (especially with regards to a rapid taper of asset purchases) will be the behaviour of peripheral government debt yields in the interim. We have already seen substantial widening in the latter’s spread over core government bonds, which risks ‘fragmentation’ of the ECB’s monetary policy. This is something that the ECB has committed to avoid, but history suggests is inescapable.
We are witnessing a sea change in developed market central banks’ reactions, who now recognise they are now behind the curve in tightening financial conditions. However, monetary policy is an extremely blunt tool for the current situation because it cannot fix the supply-side shortages that are exacerbating inflationary pressures.
Central bankers seem to be fixated on the worry that the combination of a tight labour market and high inflation could lead to a de-anchoring of inflation expectations. This would warrant rate hikes being front loaded. However, the market has extrapolated this, and a significant degree of monetary tightening appears now to be priced into the front end of yield curves (shorter maturities). This pace of tightening may well prove hard to deliver.
1Source: Bank of England Monetary Policy Report. Based on forward overnight swap rates in the 15 working days to 26 January 2022.
2Referring to the forward curve, which measures expected energy prices in future years.
3Referring to the forward curve that measures the interest rate expected to apply in future years, which is inverted (ie, lower interest rates in the future).
4Difference in the yields of a periphery government bond (such as Italy) over that of the equivalent German government bond.
Bond yield: the level of income on a security, typically expressed as a percentage rate. Note, lower bond yields mean higher prices and vice versa.
Consumer price index (CPI): a measure that examines the price change of a basket of consumer goods and services over time. It is used to estimate ‘inflation’. Headline CPI or inflation is a calculation of total inflation in an economy, and includes items such as food and energy, in which prices tend to be more prone to change (volatile). Core CPI or inflation is a measure of long-run inflation and excludes transitory/volatile items such as food and energy.
Gilts: British government bonds sold by the Bank of England, done to finance the British national debt.
Hawkish: (hawkish central bank language) refers to policymakers being more in favour of raising interest rates.
Yield curve: a graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.
Monetary policy: the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Quantitative easing: an unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.