Relative Normality On Horizon — But Divergent Monetary Policy Pathways Likely

Exclusive insight for TMI subscribers! Northern Trust Asset Management share a monthly market commentary for treasurers.

Eurozone Market Update

The European Central Bank (ECB) is not as far along the hiking cycle as the Fed or Bank of England (BoE) and has some catching up to do. Focussing on core inflation, not headline rates, it also went for a 50 basis point (bp) rate rise, in line with market expectations and taking the deposit rate up to 2%. The ECB’s approach was seen as hawkish. Clear in its intent and viewing market expectations as too low, the ECB said that ‘based on the substantial upward revision to the inflation outlook, [it] expects to raise [rates] further’. The market responded by repricing both February and March meetings to reflect strongly anticipated 50 bp hikes. The ECB surprised the market by announcing that, from the beginning of March 2023, the asset purchase programme (APP) portfolio — but not the pandemic emergency purchase programme (PEPP) — will decline on average by €15 billion per month until the end of the second quarter of 2023. Peripheral and credit spreads reacted negatively to the hawkish statement, causing the Italian 10-year yield to jump over 30 bps — the biggest move since 2020. The core government bond yield also rose significantly, led by the front end yield, which caused yield curves to flatten.

UK Market Update

The BoE hiked rates by 50 bps in December, bringing the base rate to 3.5%. This was widely expected and already priced in by many. However, the real interest lay in the voting pattern of the Monetary Policy Committee. A divergence of views emerged, with reactions against an increasingly likely stagflationary UK scenario compounded by housing woes. The vote split — two, six and one members voting for rate hikes of 0 bps, 50 bps and 75 bps, respectively — was perceived as dovish, in contrast to the hawkish approach of the ECB. The implied peak rate for 2023 in the UK rose 13 bps over the month, ending December at 4.70%. Interestingly, where ‘mortgages’ had been the November meeting’s watchword, December’s focus switched to concerns around ‘wage growth’. The broad conclusion is that peak tightness has passed for now. In inflationary terms, December Consumer Price Index (CPI) data dipped from 11.1% to 10.7%. BoE projections revised the second quarter 2023 CPI downwards by 0.75%. Only supporting data can add confidence to its approach.

US Market Update

At their December meeting, the Federal Open Market Committee (FOMC) unanimously voted to raise interest rates by 50 bps as expected, downshifting from four successive 75 bp hikes. This brings the upper bound of the Fed’s target to 4.5%. Another 50 bp hike is still anticipated for February, with 25 bps an unspoken possibility thereafter. U.S. monthly CPI inflation was at 0.1% in November versus the expected 0.3%. Core inflation for November was at 0.2% versus the projected 0.3%. Core Personal Consumption Expenditures Price Index expectations were revised upwards to 3.2%-3.7% for 2023. All this will raise expectations of a pause from the Fed before the BoE and certainly the laggard ECB, both of which will be watching Fed moves closely.

Looking Ahead

After a tumultuous 2022 for central bankers, we expect 2023 to trend back towards some form of normality (see Chart of the Month). The Fed and BoE have made great strides to reduce monetary policy slack in the system, with policy rates moving into restrictive territory. The ECB remains a laggard with some catching up to do. Interest rates during the first quarter of 2023 remain on an upward path, but the pace of ascent should slow. The cost-of-living squeeze will dampen the growth outlook, hopefully reducing inflationary pressures. If the fall-off in growth and inflation is significant, central banks may have an opportunity to pause their hiking cycles, with some market participants expecting rate cuts during the second half of 2023; however, the latter is not our base case. Wage cost pressure, services costs and subsequent core inflation measures may derail the market expectations of interest rate cuts. All of the above could see developed-market central banks pursuing divergent monetary policy paths in the latter half of 2023, the ECB, in particular, continuing quite hawkishly with its policy. As ever, the data will dictate the course of action.

Chart of the Month: 2022's Soaring Rates Outdid Market Expectations

Source: Bloomberg. As of 05/01/2023

Sign up to the Liquidity Link Newsletter

Latest News & Insights Across Global Liquidity Markets

Northern Trust Asset Management welcomes you to the full Liquidity Link Newsletter, our monthly publication offering timely updates on the UK, Eurozone and US markets - along with the latest:

• Videos
• Webinars
• Thought leadership (including blogs, articles and case studies)

_{For Europe and Asia-Pacific markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.}

_{This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.}

_{Forward-looking statements and assumptions are Northern Trust’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.}

_{The Northern Trust Company of Hong Kong Limited (TNTCHK) is regulated by the Hong Kong Securities and Futures Commission. In Australia, TNTCHK is exempt from the requirement to hold an Australian Financial Services Licence under the Corporations Act. TNTCHK is authorized and regulated by the SFC under Hong Kong laws, which differ from Australian laws. In Singapore, The Northern Trust Company of Hong Kong Limited (TNTCHK), Northern Trust Global Investments Limited (NTGIL), and Northern Trust Investments, Inc. are exempt from the requirement to hold a Financial Adviser’s Licence under the Financial Advisers Act and a Capital Markets Services Licence under the Securities and Futures Act with respect to the provision of certain financial advisory services and fund management activities.}

_{Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc. (NTI), Northern Trust Global Investments Limited (NTGIL), Northern Trust Fund Managers (Ireland) Limited (NTFMIL), Northern Trust Global Investments Japan, K.K. (NTKK), NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd and investment personnel of The Northern Trust Company of Hong Kong Limited (TNTCHK) and The Northern Trust Company (TNTC). ).© 2023 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.}