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Central banks double down to fight inflation
Macro

Central banks double down to fight inflation

At their last meeting, the European Central Bank decided to take a strong stance to regain credibility in managing inflation expectations.
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29 JUN, 2022

By Mauro Valle from Generali Investments

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It has been a tumultuous week for global fixed income markets, after major central banks hiked rates sharply to combat inflation. After stronger than expected US inflation data, the Federal Reserve hiked rates by 0.75% and the market is expecting rates to end the year at around 3.25-3.5%.

The key risk is that steep hikes will lead to a repeat of the 2018 global sell-off of risky assets and an economic slowdown, as demonstrated by the noticeable tightening of financial conditions in recent weeks. The US 10-year Treasury yield, an economic bellwether, touched 3.5% before the last Fed meeting, raising the risks of a Fed-induced recession. The upward movement was fully driven by real rates (nominal rates minus breakeven rates), which reached 0.81% before retracing to 0.60% area. Breakeven rates declined to a four-month low and stabilised at around 2.6%, reflecting the Fed’s determination to keep inflation expectations under control, albeit accompanied by a weaker growth outlook.

Given the Fed is willing to risk a recession to fight inflation, the yield curve should invert as markets price this in. The next move is expected to be a hike of 0.5- 0.75% and the market’s pricing for December is close to the Fed’s “dot plot” level of 3.5%. If the US economy remains resilient, US Treasury yields should break the 3.5% mark, reflecting a possibility that Fed rates will rise to 3.75-4.00% in 2023.

The Fed is committed to fight inflation but is also aiming for a soft economic landing. I expect that the cooling of the economy and lower inflation in the second half of the year will lead the Fed and other central banks to a slower pace of tightening compared to actual market pricing.

Turning to the Eurozone, we probably have not yet seen the peak of inflation. At their last meeting, the European Central Bank decided to take a strong stance to regain credibility in managing inflation expectations. After the announcement of a 0.25% hike in July – the first rate hike in eleven years – the ECB will probably hike another 0.50% in September and then reassess the situation. Markets are expecting rates to end the year at 1.75%.

In response, 10-year German Bund yields touched 1.80% before falling to 1.6% after the ECB’s announcement of an “anti-fragmentation tool”, which will aim to manage the divergence of borrowing costs across Eurozone countries. European real rates increased up to -0.37%, returning to the peaks observed in the pre-Covid period. With this sharp rate repricing, financing conditions have tightened too much and too quickly, raising the risk of a recession, particularly considering the risks from the war in Ukraine (ie gas cuts).

Markets are now waiting to see at what point Bund yields will stabilize. After summer, inflation data and the resilience of the European economy will determine further moves in yields, as will additional policy details from the ECB.

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