Volatility jumped this week as geopolitics dominated world headlines. Investors are looking to past crises to assess the likely duration of the large market moves we have seen and when they might reverse. A crucial medium-term factor for global risk assets, however, remains the prospect of major central banks raising policy rates and withdrawing pandemic-era liquidity.
Increasingly, investors expect leading central banks to counter surging inflation in Europe and the US. Eurozone inflation rose to a multi-decade high of 5.1% in January, while inflation in the US rose to over 7.0%, also a multi-decade high.
Tight labour markets are seen as one reason for the inflationary pressures, driving central banks to shift from gradual policy normalisation to hawkish tightening.
Another cause of higher inflation has been the rising cost of energy – and other commodities – as markets fret that the conflict on Europe’s eastern edge could curtail supplies.
Greater focus on expected rate rises…
The ECB has signalled that its tolerance of higher inflation is shrinking and, hence, the pace of its exit from pandemic era policy may accelerate. The governing council has adopted a hawkish tone and its focus on flexibility and optionality suggests that the ECB could act at every meeting in any direction, if needed.
Compared to last December, ECB President Christine Lagarde voiced more concern about inflation in January by highlighting that the inflation risk was tilted to the upside. She argued that inflation was now getting close to the ECB’s target. She did not rule out the possibility of interest rate rises this year.
As a result, our macroeconomic research team has brought forward its forecast for the end of the ECB’s asset purchase programme (APP)to September from the first quarter of 2023 and added one 25bp rate rise in December to its outlook (previously the first increase had been expected in Q4 2023). It now foresees three 25bp rises in 2023, taking the deposit rate to 0.5% by the end of 2023.
…or even monetary policy overshooting
Over in the US, January’s strong CPI inflation has fanned market jitters about more aggressive tightening by the Federal Reserve. Some investors now worry about Fed over-tightening hurting GDP growth, especially when fiscal policy is no longer as stimulating as it was last year. Indicators of US financial conditions, notably the mortgage rate, have worsened. The mortgage rate is probably the single most important channel of monetary policy transmission to the US economy.
Minutes from the Fed’s FOMC meeting showed that policymakers were ready to remove monetary policy accommodation ‘soon’ and the tightening would be undertaken more quickly than during the 2015 cycle. The minutes did not give any clues as to whether the rate hike expected in March would be 25bp or 50bp, but the tone was consistent with a ‘nimble’ Fed.
We expect the Fed to start raising rates by 25bp in March, with a possibility of rate rises at each FOMC meeting this year.
China moves in a different direction
While the developed markets’ inflation has climbed to multi-decade highs, inflation in China has continued to sag: January CPI inflation rose by only 0.9%. China’s inflation is now the lowest across the Asia region, and producer price inflation is easing quickly.
As a result, the gap in consumer price inflation between China and the US has widened to -6.6 percentage points – the largest negative monthly gap since the early 1980s.
This underscores the divergence in monetary policy between the world’s largest economies. The People’s Bank of China has been signalling further policy easing to counter weak growth. The authorities are even tweaking their property market and zero-Covid rules to deal with the weak growth.
China’s closed capital account should help limit the impact of this policy divergence on the renminbi. The currency has defied market expectation that a narrowing China-US yield spread would weaken it.
Indeed, the central bank has been intervening in the foreign exchange market recently to curb the renminbi’s strength. This is adding liquidity to the Chinese system, augmenting other policy easing measures aimed at boosting growth. While the US stock market is facing central bank policy tightening in the coming months, Chinese equities appear to be walking into a benign liquidity environment, which should help the market to recover.