Following a week of central bank announcements should we expect rates to rise in the UK and Europe sooner than we thought previously? How has this impacted the markets?
For the best part of 2017, investor expectations of future interest rate increases have aligned with central banks views. Hence when the US Federal Reserve (FED) raised interest rates twice this year, the impact was quite small. In the UK, no changes were anticipated over the medium term considering the political turmoil of the newly formed coalition government and heated Brexit negotiations. These expectations started to shift earlier this month when the Bank of England (“BoE”) decided to keep rates on hold but only by a narrow margin of five members to three.
This week, the European Central Bank (“ECB”) held its forum on central banking with most major central banks attending. The various statements delivered by policymakers were broadly interpreted as a hawkish shift. The ECB’s president, Mario Draghi, fuelled this hawkish notion by referring to “adjusting the parameters of its policy instruments”. Even though the commentary surrounding those words were much more sanguine, this was judged as the first indication that the ECB deems the European economic recovery strong enough to taper the purchase program sooner than later.
After Draghi’s comments the governor of the BoE, Mark Carney, followed suit. He referred to a lessening of the trade-off between economic growth and inflation as potential trigger for policy tightening. To understand exactly what he means by that terminology, we need to revisit central bank policy over the past year. Following the Brexit vote, the BoE decided to loosen policy by cutting interest rates by 0.25% and increasing asset purchases. The sharp decline in sterling led to higher costs for imported goods has had an impact on consumer wallets. Despite inflation breaching the Bank’s 2% target and remaining above target, the BoE previously decided to leave policy unchanged. Raising interest rates may stem price pressures by boosting the currency but could potentially come at the expense of economic growth and the labour market. So governor Carney basically said that if the broader economy holds up, the tolerance for above target inflation is limited.
The statements by both central banks could potentially mark a shift a policy. The ECB had been expected to announce a form of tapering in its September meeting and to start raising interest rates toward the end of 2018. The futures market is now pricing a potential increase in interest rates at their meeting in June 2017. With fading political risks, stronger growth survey data and an improving labour market, it seems appropriate to gradually adjust monetary policy. The current interest rate in the Eurozone sits at -0.4% which has pressured the European banking sector hence it is easy to understand the drive to move away from a negative interest rate policy. In the UK the picture is more challenging, the consumer appears more constrained by rising price pressures and economic activity could slow as a result of this squeeze. The manufacturing sector has gained momentum but whether this is enough to stem pressures elsewhere in the economy only time will tell. We could see economic conditions that could warrant the BoE to increase interest rates play out later this year, but subsequent rate increases in that scenario would likely be limited in scope and pace. (The tightrope that the Bank of England finds itself in was the very topic that was discussed in last week’s blog).
Government bond yields have risen significantly since these announcements, yet they are still lower than levels we saw earlier in the year as the market’s confidence in the reflation story from 2016 waned. Central banks are not rushing to the exit quite yet but are trying to signal to investors that current expectations for future policy adjustments have decreased too much. If the global growth momentum accelerates significantly then we could see much faster policy tightening but at present these conditions do not seem likely.
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