The world’s major central banks are almost done with rate hikes says Standard Chartered chief analyst Rajat Bhattacharya, alluding to the underlying message from the European Central Bank this week, a message likely to be echoed by policymakers from the US and UK next week. The Bank of England could hike once or twice more, given persistent wage pressures, but slowing growth, especially in Europe, suggests policymakers will soon be done with their job of taming inflation and shift their focus towards avoiding a hard landing.
Investment implications: the banker sees an opportunity for investors to move their cash into longer-maturity Developed Market government bonds within a diversified foundation allocation since government bond yields typically peak around the time policy rates peak (see page 4 for more details). The Bank of Japan is an outlier among major central banks, as it warms up to ending its ultra-loose policy due to rising inflation pressure. However, a moderate monetary policy tightening is unlikely to dent the outperformance of Japanese equities, given the upturn in corporate earnings, rising corporate dividends, and buybacks. In FX, the EUR/USD’s sharp decline to a six-month low following the ECB’s dovish hike raises the risk of further downside towards 1.0520 support in the next 2-4 weeks. GBP/USD broke below key support around its 200DMA at 1.24, opening the way for a test of 1.22 in the coming weeks.
Fed watch: Rajat sees a low probability of the Fed hiking this month. The Powell-led Fed has rarely surprised markets and markets are not expecting a hike next week. While the US central bank could keep the door open for one last hike in November, given the latest bounce in core inflation to 0.3% m/m, a still-tight job market, and the ongoing rebound in oil prices, we expect a downturn in growth later this year to sustain the disinflationary trend. The Fed’s new growth, inflation and rates (‘dot plot’) forecasts will be keenly watched. Any upward revision of the median long-run rate estimate would signal that the Fed believes rates are not tight enough despite the 525bps of hikes in this cycle, taking rates to a 22-year high.
Do we still get a US recession? A US recession over the next 6-12 months remains a base case. The US Leading Indicator (LEI) has reported a y/y decline for the past 16 months. The US has never avoided a recession after such a long stretch of decline in the indicator. Similarly, the US government bond yield curve has remained inverted (shorter tenure bond yields have remained above longer tenure bond yields, an unusual phenomenon) since July last year. At its extreme in March and July this year, the US 10-year bond yield was almost 111bps lower than the 2-year yield, the biggest inversion since 1981. Historically, a US recession has started 9-22 months (median: 16 months) after the 10-year yield fell below the 2-year yield (this cycle: July 2022), 2-16 months after the curve became most inverted (this cycle: March and July 2023), and 2-6 months after the curve sustainably turned positive again (yet to happen, although in 1982, the curve turned positive almost a year after the recession had started). Based on this history, there is a high probability of a recession starting anytime from Q4 this year to Q2 2024.
A near-term upturn?: While the unusually rapid pace of rate hikes in this cycle raises the odds of a recession, the long historical lags and the wide ranges mean we should not be surprised if a recession started as late as mid-2024. Indeed, this cycle has been extended by the unprecedented fiscal stimulus during COVID, leading to a consumption boom, and the follow-up stimulus from President Biden’s green infrastructure fiscal package, leading to a rebound in manufacturing capex. Nevertheless, we expect the impact of high policy rates, depletion of excess consumer savings and fading of the fiscal stimulus to eventually lead to a downturn in economic activity over the next 6-12 months, forcing the central banks to start cutting rates next year. Rate cuts next would provide a fillip to Developed Market government bonds.
