Investment Strategy

Why major central banks remain patient

Nov 11, 2021

Our analysis suggests global central banks will likely remain patient before hiking rates and potentially ending the cycle prematurely.

After months of speculation, the Fed announced at its latest policy meeting that it will start tapering its bond buying program by $15 billion per month, and sent a relatively dovish signal compared to market expectations. In light of inflation concerns around the globe, and while central bank rate hikes are a “when”, not an “if” question, the Fed and other major central banks will likely prove more patient than the market is currently expecting.

In this cycle, inflation has been much higher than has historically been the case. There are multiple reasons behind this phenomenon. The COVID pandemic has always had the potential to be a much bigger supply side problem, because of the disruption to production, supply chains and international logistics in a de-synchronized global recovery. Unfortunately some part of this worry became true this year when we witnessed production shutdowns across emerging markets. At the same time, the extraordinary stimulus support in developed markets meant that consumers were able to spend through most of this year, with mostly unscathed household balance sheets. On top of that there is also an energy transition occurring in the background, which is supporting commodity prices. Last but not least, as the labor market in developed markets continues to heal, slack is diminishing, and wage growth is starting to rise.

Although analysts spent a lot of time debating to what degree the resultant inflation is ‘transitory’, in reality a lot is unknown. Supply chains, for example, are hard to forecast. To this end, inflation prints still have the ability to surprise as well as impact market sentiment. But in our view, the real question has always been - what will central banks do about all of this uncertainty? Over the last few weeks, global rates markets went through some big gyrations as the markets and central banks attempted to navigate the inflation uncertainty. Notably, the Bank of Canada recently ended its QE programme earlier than expected and is now expected to raise rates. The Reserve Bank of Australia abandoned its yield curve control target. The Norgesbank has already hiked by 25bps. In emerging markets, Russia, Brazil and Mexico have all raised rates.

At the same time, bigger developed market central banks are trying to push back against earlier tightening. The Bank of England, having signaled hawkishness for some time, ended up not even ending its QE programme. The ECB has also largely maintained an accommodative stance. The Fed has perhaps been the clearest, in suggesting that it is not yet time to discuss rate hikes.

The chart below shows how a selection of central banks are reacting (or expected to react) to higher expected inflation over the next two years. In general, the larger the year-to-date increase in consensus expectations for inflation in 2022 and 2023, the greater the monetary tightening expected to be delivered by the end of next year.

In our view, inflation credibility is what separates those central banks that can be patient in the face of near term inflationary pressures, from those that cannot. Focusing on the U.S., baseline expectations across markets, surveys and professional forecasts are generally aligned at the moment, collectively suggesting that longer-term inflation expectations are in fact well anchored around 2%. The same is true for the Eurozone, although if anything, expectations may be too low considering the ECB’s 2% objective – in any case, hardly a concern that would warrant the ECB to be forced to tighten too quickly. On the other hand, market implied risk premiums for the U.K. suggest a higher probability of an inflation overshoot in the next five years.

The chart below shows market-implied inflation risk premium across U.S., U.K. and EU markets. The bottom line: markets are pricing a higher probability of inflation exceeding 3% in the US and EU on average over the next five years than falling below 1%. But the relative price of protecting against high vs. low inflation outcomes is in line with what was seen in the early post-crisis period. In the U.K., however, inflation risks seem more significantly skewed to the upside than at any time in the post-crisis period. In our view, this helps explain why the Bank of England has been more jittery with respect to recent inflation developments, while the Fed and ECB can afford to be more patient. In our view, that’s a good thing for markets.   

To sum up, while more sustainable forms of inflation like wages are starting to show, our analysis suggests global central banks will likely remain patient before hiking rates and potentially ending the cycle prematurely. That said, not all central banks are able to look through near-term inflationary pressures – regardless of their source – and hence there is a growing shift among policymakers toward more restrictive policy. The good news, in our view, is that the most important central banks for market sentiment (the Fed chief among them) have significant inflation credibility, which can allow them to remain patient.

What does it mean for investors?

The fact that both the Fed and the ECB are able to look through near-term inflationary pressures underscores our constructive view on global risk markets. Hence we continue to feel comfortable taking advantage of the re-pricing in short-dated U.S. rates and moving out of cash and into short- and intermediate-dated bonds to take advantage of the extra yield they now offer. Meanwhile, we continue to like global equities, but broadly we favor developed markets over emerging markets, where central banks are able to remain accommodative for longer in the face of higher- and stickier-than expected near-term inflationary pressure. Within emerging markets, we have to be more selective around countries and sectors navigating the highly uneven recovery as well as the winners and losers of higher commodity prices.

The key risk to our view is that any sign of de-anchoring long-term inflation expectations in the U.S. and Europe would be an upset to the constructive setup. This would likely result in a more aggressive tightening cycle, potentially ending the cycle prematurely. But so far that remains a tail risk rather than our base case. 

All market and economic data as of November 11, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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