Central banks stick to inflation fight, but for how long?

The Bank of England followed the Federal Reserve on Thursday, and hiked interest rates by 25 basis points. Interest rates in the UK now stand at 4.25%, and this was the eleventh consecutive rate increase. The BOE voted to raise interest rates by 7-9. There is a pattern going on: central bankers are willing to focus on inflation even in the middle of upheaval for the banking sector. However, their next moves could be harder to predict, and central bankers could be more varied in their approach as we move towards Q2 and beyond. This could have major repercussions on financial markets, especially the G10 FX space.

What’s next for central banks?

Broadly, going forward we expect the ECB and the Bank of Japan to lead the way with further tightening later this year, while the Federal Reserve and the BOE could be close to the peak for interest rates and may decide to pause in the coming months. The next meetings for both banks are in May, which will give central bankers plenty of time to assess the economic fallout from the collapse of SVB in the US, and the tumult in the medium-sized banking sector in the US, and the after effects from the takeover of Credit Suisse. However, central bankers may need to change the metrics that they use to assess the economic impact of the banking crisis: rather than looking at monthly inflation and employment data, which remain strong, they may want to switch their attention to lending surveys that will be released in the coming weeks. Any signs that banks are becoming less willing to lend, or that lending is becoming more expensive in the real economy, could trigger central banks to hold off from further rate hikes, especially in the US and the UK as these central banks were the first to tighten rates. Thus, the ECB and the BOJ may have some more catching up to do.

US rates hit their peak, according to the market

Looking at market expectations for future interest rates, in the US, the market now expects rates to peak at less than 5% in May, with the terminal rate now expected at 4.94%. There has also been a massive re-pricing of interest rate expectations for later this year, the market now expects 100 basis points of cuts between May 2023 and January 2024, only a few weeks ago the market was expecting the Federal Reserve to remain on hold for most of 2023. This is a huge, and guess what? It’s good news for banks. The rapid pricing in of lower interest rates this year has caused a sharp steepening of the US yield curve. Although it is still in negative territory at -48 basis points, the decline in short term yields is faster than the decline in long term yields, and if this continues then we could quickly see the US yield curve return to positive territory and a more normal shape. Since banks lend long, and fund themselves using short term debt, a steepening yield curve is better for their profit margins. Thus, it is no wonder that the US banking sector in the S&P 500 is up more than 1% on Thursday, even with all the recent turmoil.

Tech sector likes what it hears from the Fed

Yesterday, the market had rushed to buy banks after US Treasury Secretary, Janet Yellen, suggested that the Federal government would support guaranteeing all bank deposits in the US, regardless of size. However, she back pedalled on this later in the day, which caused some shock waves, especially for the beleaguered First Republic Bank, which has seen its stock price fall another third this week, although it is stable on Thursday. Perhaps the biggest winner from the shift in the yield curve is the tech sector, and the Nasdaq is up more than 2% at the time of writing. The Nasdaq is up more than 13% so far this year, however there could be further to go, as this index remains 14% lower than this time last year. Thus, if interest rate cuts continue to get priced into the Fed Funds rate, expect the tech sector to outperform, alongside bonds. While we may not get back to the 2021 highs, we do expect quality tech companies to outperform in the medium term.

Has the dollar lost its haven status?

On the FX front, the dollar is weaker yet again on Thursday, and the dollar index has proven that it is more closely aligned with US interest rate expectations rather than being a haven during the recent banking turmoil that we have experienced. The dollar is close to its lowest level of the year, which is around 101.20, currently the dollar index is trading around the 102 handle. Watch this index closely if you trade stocks, as it has resumed its negative correlation with stock markets. Thus, as the dollar dives then stocks tend to benefit.

BOE: one more hike expected

Elsewhere, the BOE also raised interest rates on Thursday, however, it left its options open about the future. It also said that it didn’t expect 1, the UK to slip into recession this year and 2, for living standards to deteriorate further. This is a big call after headline inflation rose more than 1% last month. The market now expects less than one more rate hike from the BOE, with rates expected to peak at 4.46% in August. Currently, there are 30 basis points of cuts priced in by February 2024. We think that market-based interest rate expectations are a useful tool to tell us what the market thinks in the short term, however, it may not be the best metric to trade with in the medium to long term. The last couple of months have told us that expectations for interest rates and government bond yields can be extremely volatile. Thus, looking forward, we will have to see if the market has lost a safe harbour in the storm, and if government debt becomes more volatile as interest rates normalise. We will interrogate the notion of safe havens in another note; however, it is worth noting that for all the criticism of the Swiss authorities’ forced sale of Credit Suisse, and the bail-in of AT1 bond holders, the Swiss franc is still up more than 2% vs, the USD this week. This is roughly the same gain vs. the USD as the pound, but the big winner in the FX space so far this week is the EUR. The single currency is benefitting from the double whammy of a hawkish ECB and its critical response to the Swiss authorities and their treatment of AT1 bondholders.

What to watch out for next

Overall, this has been another rollercoaster of a week, but we may not see the weekend drama that we have become accustomed to. As we mention above, the next fundamental data of note that could move the market is lending data. The Bank of England’s Credit Conditions Survey should come out in April, while in the US, the regional Fed surveys, which will also be released next month, are also worth watching closely. Any sign that financial conditions are tightening could confirm that the UK and the US are done with their monetary policy tightening cycle.