Five major central banks held meetings recently, the US Federal Reserve (the Fed), European Central Bank (ECB), Swiss National Bank, and Norges Bank – the Norwegian central bank. The messages were broadly the same; inflation is still too high and policy rates will need to rise and remain at elevated levels for a while in order to bring inflation back under control.
The Fed’s updated “dot plot” and economic forecasts reflected this view. Both inflation and policy rates are expected to be higher than previously thought. Any cuts are not likely until 2024 (green line, Exhibit 1).
Not all investors appear to be receptive to this message, however, particularly those in the US. Already for several weeks, particularly since the October Consumer Price Index (CPI) release, investors have anticipated inflation slowing sooner, which would then allow the Fed to begin cutting policy rates, or pivoting, sooner. The orange line in the chart above shows that the markets are pricing in a lower peak in the fed funds rate and are expecting it to fall by summer. In fact, after the Fed’s press conference, the expected level for fed funds in one year rose only slightly (see Exhibit 2).
Christine Lagarde was rather more successful. Her message that the ECB has “more ground to cover” had the intended effect on market expectations. The level of the ECB’s deposit rate a year from now rose sharply (blue line in Exhibit 2 above).
We believe the view of investors in eurozone assets is the correct one. Core inflationary pressures are still rising in the eurozone, while they are stable in the US (see Exhibit 3).
That stability, though, does not mean that inflation will soon fall enough to allow the Fed to begin cutting rates by the summer. Recall that the latest non-farm payrolls data showed continued robust job gains and rising wages. Consequently we anticipate that US Treasury yields, particularly around 5-year maturities, need to rise.
The risk then is a reversal of the rally in both government bonds and equities we have had over the last several weeks. The sell-off in the Dow following the Fed’s press conference may be the first sign of this. Even once interest rates revert, equities are still at risk of further earnings downgrades. While 2023 earnings-per-share (EPS) estimates for US equities have already fallen sharply since the summer, they are still pricing in 5% year-on-year earnings growth for 2023, and 11-14% in the third and fourth quarters, respectively. If the US economy is in recession in the second half of next year as we expect, increases in earnings, as opposed to declines, seem unlikely.
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