While the Fed raised rates aggressively in line with its previous communication to markets, the SNB surprised with a 0.5% rate hike. And the ECB is still looking for a solution to its Gordian knot – the fragmentation under pressure of markets within the Eurozone.
Fed decision of 15 June 2022
At its meeting on 15 June, the Fed boldly raised the key interest rate by 75 basis points, leaving no doubt about the priority of price stability. The decision was made with one dissenting vote and had also been expected by the market following the release of May consumer price data which showed a year-on-year increase of 8.6%, up from 8.3% in April. Immediately after the announcement, American stock indices gave up their daily gains although Fed Chair Powell’s comment, that there would not be a series of such large steps, calmed investors, allowing a recovery towards the trading close. Most now expect a hike of 0.5% or of 0.75% at the July FOMC meeting. Based on the dot plots – FOMC member forecasts of the Fed funds rate – this key interest rate is expected to be 3.4% by year-end, about 1.7% higher than today. The futures market, however, implies a rise to 3.6%. Four more FOMC meetings are scheduled for 2022.
Mr Powell justified the June rate hike by describing an American economy that is in robust shape, with jobs being created and an imbalance between the supply of, and the demand for, goods which is driving inflation and needs to be addressed.
But tighter monetary policy only works indirectly against inflation via an economic slowdown. The hope is that the resulting slowdown will not push the economy into recession. Based on their reaction to the June meeting, markets still seem to believe a soft landing for the American economy can be achieved.
The current roadmap for quantitative tightening will be maintained. The Fed’s consistent stance on this point can be seen as a confidence-builder.
A historical digression
Since the Paul Volcker era, the Fed has raised interest rates by 75 basis points only once. That was in 1994 when inflation was 3%. But in February 1989, when inflation was just under 5%, the Fed funds rate was increased by a whole percentage point.
With US inflation well above 8%, a robust economy and low unemployment, the Fed’s move is clearly justified.
An ordinary and an extraordinary ECB meeting
The ECB’s ordinary meeting on 9 June disappointed markets in view of the economic background – high inflation in the euro area (8.1% in the year to April) and strong growth. The main decision was to postpone any meaningful policy response until the next meeting. Although the ECB is sticking to plans previously communicated to the markets, it is not living up to its mandate of price stability.
Yes, the Eurozone inflation rate is currently being driven by several extraordinary and exogenous factors. And yes, the ECB must apply one monetary policy to a very heterogeneous economy. All that said, the ECB is missing its inflation target (less than 2%) by a mile and is falling ever further behind.
Problems are once again developing in Greece and Italy, where both interest rates and interest rate premiums are causing concern. Discussions about the Eurozone-wide unification of sovereign debt and the danger of a new euro crisis are resurfacing.
The ECB’s hesitant stance risks much higher inflation than in decades becoming embedded within the economy. Such a development would markedly increase the risks for the weaker economies that comprise the Eurozone’s “Club Med”.
The extraordinary meeting of the ECB’s Monetary Policy Council on June 15 occurred following a sharp widening of spreads within the Eurozone. The resulting proposal, to be developed by a committee, further unsettled markets. The basic idea is that maturing bonds from the ECB’s €1.7 trillion bond portfolios will be invested “flexibly” to support the debt of weaker economy governments and thus prevent the fragmentation of the Euro currency zone. But Eurozone markets are already fragmented and will remain so.
The ECB’s proposal feels like old wine in new bottles and is certainly not confidence-building.
The SNB emancipates itself from the ECB
In contrast to the ECB, Switzerland’s central bank seems to be taking its mandate of price stability seriously. Its key interest rate was raised by 50 basis points. While the decision was welcomed in some quarters, we feel that the SNB could have done far more to prepare investors for the move and hope for better transparency in future as to how it views potential policy decisions.
Part of the problem has been that the SNB’s policy of trying to prevent an excessive appreciation of the Swiss franc meant that it has been viewed as reacting passively to ECB policy decisions. Although the 3-month Swiss reference (Saron) interest rate had moved from minus 0.7% in mid-May to minus 0.5% just prior to the SNB’s decision (implying a 25 basis point hike at some stage) the 50 basis point move came as a surprise in terms of both timing and scale.
As with the surprising decision of the SNB on 15 January 2015 to lift the 1.20 “peg” on the franc-euro rate, this decision undermined investor confidence. From the point of view of price stability, the interest rate increase is objectively and technically justifiable. However, the lack of communication to prepare an already nervous market can be criticised.
The consequences
The future policy roadmap
The Fed will continue to raise interest rates and implement quantitative tightening. (It has started selling from its accumulated bond portfolios). But it remains to be seen whether the ECB and SNB will now outline a clear policy path to investors.
We expect interest rate hikes, and also quantitative tightening, until at least the end of the year.
Consequences for financial markets and portfolios
Further interest rate hikes have already been “priced in” by the bond markets. And parts of the US yield curve have already inverted, anticipating that the trend to higher US interest rates will come to an end sometime in the coming year. In this context, we intend to increase the duration of our bond portfolios in stages over time.
The most likely reason for a setback in stock markets would be an increased concern on “valuation” due to higher interest rates. But we think a possible decline in corporate earnings due to a sharp slowdown or recession has not, or has only partially, been discounted by the markets. Accordingly, we recommend keeping the equity quota neutral. For trading-oriented clients, however, the current environment offers opportunities to participate in short-term rallies.
Contact: Christoph Sieger, Portfolio Manager
Telephone: +41 58 680 60 56
Disclaimer: Produced by Investment Center Aquila Ltd. Information and opinions contained in this document are gathered and derived from sources which we believe to be reliable. However, we can offer no under-taking, representation or guarantee, either expressly or implicitly, as to the reliability, completeness or correctness of these sources and the information pro-vided. All information is provided without any guarantees and without any explicit or tacit warranties. Information and opinions contained in this document are for information purposes only and shall not be construed as an offer, recommendation or solicitation to acquire or dispose of any investment instrument or to engage in any other trans action. Interested investors are strongly advised to consult with their Investment Adviser prior to taking any investment decision on the basis of this document in order to discuss and take into account their investment goals, financial situation, individual needs and constraints, risk profile and other information. We accept no liability for the accuracy, correctness and completeness of the information and opinions provided. To the extent permitted by law, we exclude all liability for direct, indirect or consequential damages, including loss of profit, arising from the published information.
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