Research Note | Interest rates: higher for longer

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    Interest rates: higher for longer
    Interest rates: higher for longer
    31 August 2022

    Key Highlights

    • Powell’s speech at the Jackson Hole symposium suggests US interest rates will stay elevated
    • The Fed appears willing to endure substantial economic pain in order to force down inflation
    • Meanwhile in Europe, rampant inflation and rising rates point to the potential for a deeper recession

    Powell’s tough talking weakens markets

    The message last week from Federal Reserve chair, Jerome Powell, was clear – the Fed will continue to raise interest rates in order to bring inflation down, even at the expense of a US economic slowdown. While this is nothing new, some optimism had crept into markets that inflation was close to its peak, and that a softening of the Fed’s stance on interest rates was now possible.

    However, Powell was uncompromising when he spoke at the Jackson Hole central bank conference last Friday. He pointed out that history cautioned against “prematurely” loosening policy and that the US would "keep at it until we are confident the job is done". This, he said, would "likely require restrictive policy for some time"..

    These words sent US markets into a tailspin, with all major US indices falling by over 3.0 percent. But having had the weekend to digest the news, the Asia Pacific market correction on the following Monday were more subdued, with the Japan and Korea indices down by 2.0 to 3.0 percent and Hong Kong and Australia down by 1.0 to 2.0 percent.

    More rate hikes to come

    Importantly, Powell reiterated the Fed’s inflation target of 2.0 percent. He stressed that a return of inflation to this level was a necessary condition for positive economic outcomes in the future. Minneapolis Fed President Neel Kashkari subsequently reinforced this, saying, “People now understand the seriousness of our commitment to getting inflation back down to 2 percent”.

    This strongly suggests that the Fed does not view a stabilisation of inflation to be an adequate criteria for easing current interest rate trajectories. And while the current market consensus is for a 50 basis point (bps) rate hike at the Fed’s September meeting, Powell hinted that he was open to more aggressive action. He noted that, "July's increase in the target range was the second 75 basis point increase in as many meetings, and I said then that another unusually large increase could be appropriate at our next meeting. We are now about halfway through the intermeeting period.”

    As a result, 10-year and 2-year Treasury yields, continued its upward march to reach 3.09 and 3.42 percent respectively. Not only are bond yields rising again, but the 2s10s spread (that is, the difference between short and long term Treasuries) has turned negative, both leading to increasing recessionary fears.

    Europe reels under inflationary pressures

    Now all eyes are on Europe. Against months of policy tightening by the US Fed, the European Central Bank’s (ECB) rate rises have been far more modest. The ECB’s first rate hike in 11 years, of 50 bps, only started in late July, much later than the Fed. Given that European rates had been negative since 2014, the ECB’s rates are far behind the Fed’s rate of 2.25 to 2.50 percent.

    This despite that fact that annual inflation in both regions is now at similar levels, with Euro area inflation registering 8.9 percent in July, compared to US’s 8.5 percent. It is notable however, that inflation in the Euro area continues on an upward trend, whereas US inflation may have peaked in June at 9.1 percent.

    There is good reason to suspect that Euro area inflation has a long way to go. The price of natural gas, an energy source on which Europe is highly dependent, has surged almost 20 percent this month and is 2.5 times higher than at the start of the year.

    Figure 1: Natural gas price (USD/MMBtu)

    Figure 1: Natural gas price (USD/MMBtu)

    Source: Trading Economic/UOBAM

    This explosion in the price of natural gas is causing electricity bills for European households to rise by five to 10 times their pre-Covid levels. Further increases will depend on whether Russia further tightens its squeeze on gas supplies to Europe, having already significantly reduced flows in recent weeks.

    Global impact of a European spillover

    Faltering eurozone growth, plus a more measured approach to rate rises, is also set to keep the euro weak. This month, having fallen below parity with the USD for the first time in two decades, there are fears that the EUR/USD could fall further.

    This would exacerbate inflationary pressures, and further threaten the region’s growth prospects. There are already several alarm bells ringing. The European Commission’s monthly Economic Sentiment Index fell again in August with industry and services accounting for the biggest drop in optimism.

    In the event of a deep European recession, coupled with considerably slower growth in the US and China, there is a danger that the 3.2 percent global growth forecast for 2022 will not be met. The International Monetary Fund (IMF) warned in a recent report that, “The world may soon be teetering on the edge of a global recession, only two years after the last one.”

    However, this is not a foregone conclusion. Unemployment in the euro region remains low and stable, and the European Commission’s growth forecast for the EU economy is 2.7 percent in 2022 and 1.5 percent in 2023. We recommend caution and a neutral positioning in this highly uncertain environment. Our base case is for 2022 to remain volatile, but for the global outlook to start to improve in 2023.


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