Will the pace of rates hike be faster?

Traders and investors are primed for a relatively modest rate-hike cycle although inflation is running, or is expected to run, at up to three times the 2% target. 

However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks that the markets are being too optimistic here; rate hikes by the BoE and Fed in 2022 and probably beyond, are likely to be more than the markets are pricing in.

Both the Fed and Bank of England have produced hawkish policy surprises this week. The BoE hiked rates 15-bps when most expected no change, while the FOMC’s median fed funds forecast for next year posits three rate hikes, not the two that the market was anticipating. This being said, these surprises are not huge.

“We knew that the BoE’s decision was on a knife-edge, while the rest of the Fed’s pronouncements, such as a doubling of the taper, were in line with expectations. But we think we should get used to central banks delivering more than the market expects and, in our view, even delivering more than they anticipate right now. This is most easily seen in a US context because the Fed lays out its forecasts of all 18 FOMC members. In this week’s set of forecasts, the median projection is for the fed funds rate to be 0.9% at the end of 2022, 1.6% at the end of 2023, and 2.1% at the end of 2024. If we concentrate on this end-2014 forecast, it is around 2-4 rate hikes more than the level suggested by the market depending on whether you use fed funds futures or OIS rates. But even this FOMC forecast does not put the fed funds rate back to what is believed to be the ‘neutral’ rate, of 2.5%, let alone to the levels that would imply a contractionary monetary policy. We find it hard to believe that the Fed – and the BoE for that matter – can bring inflation back to target within the next few years without putting monetary policy into a contractionary setting”, Mr. Steve Barrow said.

Of course, the banks can use a rundown of their assets to impart less monetary stimulus and possibly avoid the need for policy rates to rise above neutral but, this is questionable. For one thing, a lot of heat, particularly in the US is in the housing market and unless tapering and – at a later stage – asset rundown can produce a decent rise in yields and hence mortgage rates, it seems likely to us that policy rates will have to rise to neutral levels, if not more. The same applies to the UK although here we don’t have the advantage of a formal Bank of England call on the neutral rate. But even if it is quite a bit below the US estimate of 2.5% it still seems that the market is not anticipating base rates rising above the neutral rate as the market seems priced for base rates to rise to little more than 1%.

“We can certainly understand why traders and investors are more hesitant than central banks about assuming steep rate hikes ahead. The history of the post-global financial crisis period has generally been one in which central banks have underdelivered on rate hikes given the persistence of very low inflation. But the key question now is whether this era of low inflation, if not over, is at least going to require steeper rate hikes to bring it back. In our view, the world is not moving into a high inflation era reminiscent of the 1970s or anything like it. But we do think that tacking inflation will be harder than the central banks think – and much harder than the market perceives. The BoE and Fed gave a hint of this, perhaps, with hawkish pivots this week and, in the future, we think they will both have to pivot further. For the Fed, we look for rate hikes to start in Q2 next year and expect the Fed to deliver a 25-bps rate high roughly every quarter until rates get close to the neutral level. The BoE too seems likely to deliver roughly one 25-bps rate hike each quarter until rates rise to at least 2%. Financial markets are far adrift of these sorts of levels and catching up could prove more painful than we have seen so far this week”, Mr. Steve Barrow forecasted.