The Fed, the BOE and the ECB all announced policy decisions within 24 hours this week and there was a collective 125 basis points of tightening. However, stocks surged and the Nasdaq closed up some 3.25%. The market reaction was euphoric: all US and European indices are higher on Thursday; bond prices are up (yields lower) on both sides of the Atlantic and even Bitcoin is higher on the day. The messages from the world’s major central banks were hardly dovish, so why are markets reacting like this? A good summary of the Fed, ECB and BOE meetings is that the market is forward-looking, and they are willing to look through the short-term hawkish guidance from these central banks to brighter times ahead. The extent of the move in the bond market was staggering: UK 10-year Gilt yields dropped by 30 basis points on Thursday, Italian 10-year yields fell by 40 basis points and US Treasury yields fell by 4 basis points. Thus, financial conditions are loosening, even if central banks are continuing to tighten.

The Fed:

The Fed’s statement said that ongoing increases in interest rate hikes are likely (probably in March and May), which could push interest rates to a 5% - 5.25% terminal rate. This is slightly higher than what the market was anticipating prior to the meeting, with US interest rates expected to peak at the 4.8% - 4.9% range. However, the statement also noted that inflation has eased somewhat, and it changed the wording in its statement to say that the war in Ukraine is contributing to “global economic uncertainty” rather than “upward pressure on inflation and weighing on economic activity”.

Jerome Powell’s press conference had both hawkish and dovish elements. For example, he said that the economy had already slowed significantly, and a slower pace of rate hikes would allow the Fed to better evaluate the Fed’s progress towards its objectives. However, on the hawkish side, the Fed also said that they will also need to maintain a restrictive level of interest rates for some time. As mentioned above, the market seems to have looked through this statement, and instead taken solace in the fact that the Fed chair did not push back on market expectations for lower rates in the second half of this year.

In the aftermath of this meeting, the market has run with the Fed’s “dovish” message, it is now looking for rates to peak at 4.83% in July 2023, and for 68 basis points of cuts by January 2023.

No doubt, the Fed took solace in the notable improvement in the US’s inflation picture, particularly the decline in housing costs and a slowdown in core wage growth. The Employment Cost Index for Q4 shows that private sector wage growth was 4.1% in Q4, which suggests that wages are declining, but remain above historical averages, as you can see in the chart below.

Chart 1:

Added to this, the Cleveland fed recently released a new data series that breaks down the shelter component of core inflation. The new tenant repeat rent index has fallen sharply, this should lead to a decline in the all tenant repeat rent index and the CPI rent of primary residence sub-index. These measures suggest that not only has headline inflation in the US peaked, but so to has core inflation.

Chart 2:

The Bank of England:

· The BOE hiked rates by 0.5% as expected on Thursday.

· The vote split was 7-2, with 2 members voting for rates to remain at 3.5%, they argued that higher rates now could lead to the BOE having to cut rates quickly due to the impact on the economy.

· In a quirk that is unique to the UK, the BOE said that the Queen’s Platinum Jubilee, and then the State Funeral contributed to the decline in GDP in Q3, while the World Cup boosted growth in Q4. The UK is now expected to narrowly avoid a technical recession.

· As expected, the BOE’s growth outlook has been revised up.

· GDP is now expected to fall by 0.7% in 2023, and rise by 0.2% in 2024, and by 0.9% in 2025. The BOE also said that the UK’s neutral growth rate, where inflation won’t be stimulated, is now a mere 1%, this is less than half the rate it was before the pandemic.

· CPI is expected to fall to 3.1% by Q1 2024 and continue to fall to below the BOE’s target rate of 2%, ending 2025 at a mere 0.4%.

· The MPC’s projection for growth is based on market-implied interest rates, with rates peaking at 4.5% this year, before falling back to 3.25% in 3 years’ time.

· In the aftermath of the BOE meeting, the latest WIRP data shows that the market expects UK rates to peak at 4.27% in June, with 26 basis points of cuts currently priced in by December 2023.

· Like the Fed, the BOE did not push back on market expectations for rates to fall later this year, which was taken as a dovish signal by the market.

· There is some good news on inflation: MPC notes that pay growth has fallen for some sectors, and house prices are also declining, albeit at a lagged pace compared to the US.

· However, the BOE expects inflation to fall sharply this year when the sharp inflation growth last year starts to fall out of the index.

· Q2 inflation is now expected to be lower than the BOE’s November projection.

· Productivity growth is expected to remain weak.

· Overall, it looks like the impact of Brexit on supply growth has weighed on growth sooner than the BOE expected. It also highlights the well-established relationship between openness and productivity growth.

· The BOE noted that Brexit has had a bigger impact on trade in goods, compared to trade in services.

· The BOE also blames subdued levels of business investment on Brexit.

· The labour market could remain tight due to the fall in the participation rate, caused by early retirement and long-term sickness. They argue that there has been a large increase in people of working age distancing themselves from the labour force and are unlikely to return to work anytime soon. This will take some time to unwind and could weigh on the participation rate for the long term, it could also keep upward pressure on wages, which is one of the reasons that when it comes to inflation, the BOE thinks that the risks are to the upside.

The ECB:

· The ECB also hiked rates by 50 bps on Thursday.

· The ECB also pledged to hike interest rates again in March.

· However, it said that it would evaluate the subsequent path of its monetary policy after March, which suggests that the ECB could also be nearing the peak in its interest rate cycle, as inflation falls across the currency bloc.

· In the aftermath of the ECB meeting, the latest WIRP data suggests that Eurozone rates will peak at 3.29% in July, with 16 basis points of cuts priced in by December 2023.

· The market’s dovish assessment of the ECB meeting caused the euro to sink and stocks to rise, it also led to a sharp fall in European bond yields, in Italy the 10-year yield fell by 40 basis points on Thursday!

· Some analysts are concerned that the market is wrong to assume that the ECB is going to execute its own dovish pivot in the second half of this year, instead, it thinks that the ECB’s next dilemma will be how much to hike by after March, and that further hikes into Q2 and beyond are a given.

Central bank round-up: