Prospects for central banks’ monetary policy

The ECB and BoE could start rate cuts in Q2 next year with the Fed delayed by another quarter

>> Will ECB cut rates before the FED?

We had argued at the time that the surge in longer-term US yields back in September and October, to 5% for 10-year notes, was likely to prove an overshooting. So far this has proved the case, but many analysts are also wary that rates might have subsequently come down too far and too fast.

Generally speaking, policy rates and bond yields are likely to be higher in the postpandemic world than the pre-pandemic decades. Those pre-Covid decades were marked by things such as China’s central role in rampant globalisation that spread disinflation around the world. On top of the fall in inflation that this created, we also saw central banks lower long-term yields via huge quantitative easing.

In general, the pre-Covid years saw excess supply of goods, savings and central bank monetary largesse. The post-Covid world is likely to be characterised by more balanced, even deficient, supply. Protectionism has eroded China’s ability to spread deflation, demographic changes, speeded up by the pandemic, are denying developed countries the large pools of labour necessary to keep wage pressure down, and central banks have reversed the excess supply of money.

Few would disagree with the idea that policy rates and bond yields will be higher than the pre-Covid years. The question is how much higher? In terms of policy rates, it clearly seems likely that the “new normal” will not see rates as high as they are now. In the US, FOMC members still put the “neutral” fed funds target rate at 2.5% but that seems too low in the Standard Bank’s view.

As for treasury yields, Mr. Steve Barrow, Head of Standard Bank G10 Strategy believes that 5% for 10-year notes is also higher than the “normal” level that is set to prevail in the future. But the subsequent slide to below 4.5% has been very rapid and seemingly based on not much more than a CPI print that was a tenth below the consensus.

Essentially, what we see is that the treasury market is grappling with this “regime change”, in which the pre-Covid era of super-low rates is being replaced by higher rates. The first part of this adjustment appeared to reflect the sharp rise in policy rates, even if longer-term yields understandably lagged behind, creating more yield curve inversion. The most recent part of this transition seems to have reflected the path of fiscal policy, not monetary policy.

For the legacy of the pandemic, especially in the US, is this huge transfer of resources from the public sector to the private sector. This, of itself implies higher yields than would have otherwise existed and the fact that the US government has added to this with other fiscal support, such as the Inflation Reduction Act, has only added to the pressure.

>> What are the prospects for the euro/dollar next year?

“We still don’t feel that this fiscal deterioration implies that 10-year yields should be as high as 5%. We’d put the ‘new normal’ as being in the 3-4% range and we do think that yields will get back to this level in time. We do not think that this will be a rapid move, unless the US falls into a deep recession that requires rapid and significant rate cuts, and hence we are cautious about forecasting steep declines in yields in the short-term. Lower long-term yields should be encouraged by reductions in policy rates. But central bankers continue to stress that policy has to stay restrictive for a considerable period of time. For many this seems to mean that the rate peak will have to be maintained for some time, possibly right the way through 2024”, said Mr. Steve Barrow.

Mr. Steve Barrow doesn’t take this view for four main reasons. The first is that inflation is likely to slow and economies weaken, particularly in Europe, and hence the policy narrative will change. The second reason is that falling inflation lifts real yields and this means that policy can remain restrictive even if rates are cut. And the third reason is that if the likes of the ECB, Fed and BoE do not start cutting rates until around the middle of 2024, it will still have meant that peak rates will have been in place for 9-months or more, which is actually a very long time if you look at prior monetary policy peaks. The final justification for the fighting talk from central bankers is that to admit now that policy could be eased risks undermining current policy. Again, history shows that central bankers talk a hawkish story all the way up until the point that conditions prove conducive to easier policy.

“We see the same thing happening now and we expect the ECB and BoE to start rate cuts in Q2 next year with the Fed delayed by another quarter”, said Mr. Steve Barrow.