Fed – Terminal rate in sight
Last week, US inflation surprised again on the downside, leading to softer messaging from the Fed.
In November, US CPI inflation increased by just 0.1% on the month, the lowest print since the summer. This latest print brings the annual change to 7.1%, vs 7.3% expected. The peak in US inflation was 9.1% in June. Core inflation dropped to 6%, 0.3% below October. The composition of the change was positive too with most components dropping. Decreases were led by energy prices but extended to core components too. Airfare prices, medical expenses and the cost of cars all displayed meaningful disinflation. Shelter inflation remains elevated but increased less than in October.
Softer inflation led to a softer message from the Fed on Wednesday. As widely expected, rates were hiked by 50bp to 4.25-4.50%. New projections underscore a higher terminal rate of 5.1% according to FOMC members and worsening economic metrics for 2023. The unemployment rate forecast was hiked by 0.2% to 4.6% and growth was cut from 0.9% to 0.5%. Language on inflation suggests more comfort than in November.
Overall, we expect the Fed to lift rates to 5% before moving the focus to the economy. A period of stable rates is most likely after April as inflation will fall but remain elevated. We expect discussions around rate cuts to take place towards the end of 2023. We maintain a positive bias on US rates and a negative bias on the US dollar as the end of the policy cycle is in sight.
ECB – Hawkish surprise
The ECB meeting last week was surprisingly hawkish.
As expected, the central bank hiked the deposit rate by 50bp to 2%, but the guidance was extremely hawkish. The Governing Council raised inflation projections to 6.6% in 2023, cutting growth less than the market expected. According to updated forecasts, core inflation remains elevated throughout the policy horizon and headline inflation will stay above target until 2025. Moreover, President Lagarde explicitly discussed market pricing in the press conference, deeming the 3% eyed by markets as too low. The ECB is guiding markets for a terminal rate in the 3.25-3.5% range with some upside risk attached to it. Quantitative tightening was also announced, with a EUR15bn / month reduction starting in March and running until the summer when the pace will be increased.
In Europe, inflation is running higher than in the US and the signs are that the peak will come later. As a result, it makes sense for the ECB to be more hawkish in this phase. The change to the terminal rate will likely be 25bp higher. While markets may be concerned about more hikes in a slowdown, the ultimate target will change little, in our view. Rates markets reacted to the news via a large move across the board, with bunds moving some 30bp after the meeting and BTPs almost 50bp. We think the move is more justified in bunds where longer hikes will meet high issuance from the German government in 2023.
Markets – Deflating fears
Last week, we published our latest market views.
We think 2023 will be a year of deflating fears. Supply bottlenecks, the energy crisis and central bank tightening inflated yields and spreads in 2022. The easing of each of those tensions will benefit fixed income markets next year.
In addition, bonds are in a better position than equities due to disinflation and growth slowdown. Our analysis shows that US and European inflation will continue to drop in 2023 with US real rates positive since the summer. Both US and Europe will experience a growth slowdown towards 0%. Duration will benefit from these trends.
The slowdown will not be a deep recession and will credit therefore benefit as well. That said, we favour those areas that are more rates sensitive, such as investment-grade credit and financials. We are broadly negative the US Dollar and positive on non-US assets given the potential for China re-opening and the Fed pivot.
Algebris Investments’ Global Credit Team
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