Investors can take heart as interest rates may be peaking

Central bankers who might be seeking credibility by raising rates more aggressively to fight inflation mustn’t lose sight of the macroeconomic picture
While a soft landing for the world economy is unlikely, central bankers can help avoid a deep recession by easing off policy tightening soon

Chris Iggo

Published: 10:00pm, 2 Nov 2022

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In her press conference following the European Central Bank’s Governing Council meeting on October 27, ECB president Christine Lagarde suggested that monetary policy decisions from now on would be taken based on incoming data and an assessment of the impact of decisions already taken.

The latter point is important and something that is often missed by financial market commentators. Monetary policy acts with a lag. A decision to raise interest rates today will shape economic behaviour in the future. A series of interest rate rises – as seen in many economies in 2022 – will have an accumulated effect on demand and inflation.

The trick is to assess when enough has been done to meet central bankers’ objectives. For most, that means getting inflation back on track to where it broadly was before the Covid-19 pandemic.

The lags between rate increases and economic activity are, in the words of economist Milton Friedman, long and variable. We know higher rates affect behaviour by feeding into higher borrowing costs for households and businesses.

Those with floating-rate debt immediately feel the pinch of increased debt service payments. Those with fixed-rate debt – such as mortgages in many countries or corporate bond issuers – will do so when they come to refinance.

Higher borrowing costs also deter economic agents from taking on new debt. Borrowing at 5 per cent is less attractive than borrowing at 1 per cent. This slows credit growth, which affects investment and consumption spending.

European Central Bank president Christine Lagarde gives a press conference at the ECB headquarters in Frankfurt on October 27. The ECB has hinted that much of its policy tightening might be done. Photo: DPA

When higher central bank policy rates also lead to higher government bond yields, investors are happy to lend to governments, which are seen as “risk-free” borrowers, rather than riskier companies. This squeezes the private sector out of credit allocation.

But when and how rates affect consumer spending, investment decisions and inflation are hard to model. That is why monetary policy is as much art as science. During a rate-raising cycle, central banks tend to let data inform the decision-making process.

It is telling that, since this rate-raising cycle began, we have not heard much about the equilibrium real interest rate. There is no right level of rates that will deliver the desired inflation outcome, especially when central bankers don’t necessarily understand the forces that are creating higher inflation.

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Accepting that there are supply side effects and huge uncertainties around inflation expectations and the cost-price transmission process, central bankers must conclude that they need to dampen demand to control inflation. Higher rates and tighter liquidity conditions will eventually do this.

Much has already been done. A look at some of the major central banks shows the US Federal Reserve, European Central Bank, Bank of England, Reserve Bank of Australia and Bank of Canada have all made aggressive cumulative moves in raising interest rates. This will slow growth and inflation, and the peak of the rate cycle is in sight.

Global bond markets have got excited about this being the case. Although central bankers are reluctant to signal that they are nearly done, bond traders can smell that that a peak in policy rates is close at hand.

In recent weeks, the Bank of Canada and the Reserve Bank of Australia have slowed the pace of increases. The ECB hinted that much of its policy tightening might be done. Policy decisions by the Fed and the Bank of England have yet to be announced.

Many economists see downside risks to economic growth in the quarters ahead. The additional credibility central bankers might seek in terms of their anti-inflation stance by raising rates even more aggressively than anticipated will be overwhelmed by the loss of credibility in terms of overall macroeconomic management.

A soft landing for the world economy is probably a lost cause by this stage, but central bankers can take actions to avoid a deep recession by easing off tightening soon. If they do, this will be good for investor sentiment after a torrid year.

The US Treasury 10-year yield is in fair value territory at 4 per cent, and many parts of global bond markets offer value at current yields. This is especially so if rates don’t go up more than anticipated. There are credit concerns given the slowing of growth and corporate earnings, yet yields are high in global investment-grade credit and limiting exposure to short-duration assets is a way of exploiting peak short-term rates without taking on too much risk.

For equity investors, the worst of the earnings recession is still ahead. However, a peak in rates and bond yields should help equities stabilise. Much has already been priced in, given how equity prices have fallen in 2022. Once the peak in rates is validated by central banks, total returns should start to look much healthier as we move into 2023.

Chris Iggo is the chief investment officer for core investments with AXA Investment Managers

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