Fed – Slower for longer
Last week the Fed hiked interest rates by 75bps, as expected. Although the press release was taken initially as dovish, Chair Powell’s remarks during the press conference had a more hawkish tone, immediately reversing initial market gains. The FOMC pointed to a slower pace of rate hikes starting in December but a higher peak funds rate in 2023, and warning of the greater risks of under-hiking vs over-hiking. Overall, we expect the December dot plot will show a higher median projection of the peak funds rate. Markets are now pricing a terminal rate of 5.1% in June 2023.
Friday’s data shows that the US labour market is softening, albeit at a moderate pace and has not yet reached the point where it is screaming at the Fed to stop tightening. October payrolls rose by 261K, above the expectations of 193K, but lower compared to the September 288k print (revised to 315k). Private payrolls slowed to 233K from a revised 319K in September. Unemployment rose to 3.7%, from September’s 3.5%. Average hourly earnings increased by 0.4%. The three-month average increase, 0.32%, annualizes to 3.9%, the slowest increase since the chaos of 2020 and well below the y-o-y rate, 4.7%. Overall, market reaction to this data was quite subdued.
The Fed and market focus will now shift on the CPI print coming this week. The October CPI report should give more comfort about the inflation peak having been reached. We expect headline inflation to come at 8.0% y-o-y on Thursday, and core CPI stabilising at 6.6% y-o-y.
We believe that if the trend in labour market continues and CPI this week comes as expected, markets will start to push the Fed – and especially Chair Powell – to rethink the idea of continued hikes next year.
UK – Dovish rhetoric
The BoE followed the Fed’s lead, delivering 75bps, but surprisingly accompanied the hike with dovish rhetoric and warnings of prolonged recession. The committee motivated the step-up in the tightening pace with the additional demand stimulus provided by recent fiscal measures and continued concerns around the inflation outlook. But the MPC maintained its view that the UK economy is likely to enter a recession despite the additional fiscal support and pushed back against the extent of future rate hikes priced into financial markets.
We see the communication as consistent with expectation that the MPC will return to a 50bp pace in December. At that point, the economy will likely be in recession.
The budget has been recently moved from October 31st to November 17th, which certainly added an element of uncertainty to the BoE projections, and assumptions on the fiscal side will remain loose for now. We think the terminal rate for the Bank of England will be between 4.5-5%, in line with what the market is pricing.
Overall, potential delivery of fiscal tightening in the November budget, further soft growth data, and a slowdown in the global pace of tightening – from the Fed and the ECB – will allow the Bank to apply the brakes in December, and in 1Q23, as well.
Global bond markets – A step closer to peak hawkishness
Following the global hiking cycle, real rates have increased consistently this year and we expect them to stay close to current levels until year end. 10-year real rates in the US are at 1.7%, compared to the -1.6% in January. German 10-year real rates are at -0.10%, compared to -2% in January.
However, we think we may be close to peak hawkishness by policymakers. We have seen mixed signals from global central banks with the Fed slowing the pace of hiking but guiding for higher terminal rates, the ECB guiding for a slower pace of rate hikes and sounding marginally more dovish, the BoE also guiding for a slower pace of hiking given weak economic outlook, and the BoC surprising dovishly.
Overall, what seems clear is that terminal rates will likely peak around June 2023, with a ~5% terminal rate priced in the US and ~3% terminal rate priced for the Eurozone, which we deem as appropriate levels.
As we approach 2023, we will also see improving inflation data globally and have more clarity on the timing of potential central bank pivots. To that effect, we believe that early 2023 could see a large rebound in fixed income markets, affirming our positive view on credit.
Algebris Investments’ Global Credit Team
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