Carmignac: Comments on next week's monetary policy decisions of ECB and Fed

Carmignac: Comments on next week's monetary policy decisions of ECB and Fed

Monetary policy ECB Fed
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Kevin Thozet, a member of the investment committee at Carmignac comments on next week’s European Central Bank and US Federal Reserve monetary policy decisions.

European Central Bank

With core inflation showing no signs of deceleration, wages remaining on an upward trend and growth expectations being revised higher, there is no doubt that the ECB will bring deposit rates to 2.5% on 2 February. Especially as a 50 basis points (bps) hike is largely telegraphed by its forward guidance, provided it can be trusted – a source of much debate among investors!

The key point at issue, therefore, is not “if” but “how long” will this 50 bps hiking period last. Perhaps two meetings, per the 75 bps hiking period? Will it go beyond March? Will we, from now on, transition towards a 25 bps hiking period?

We deem that Ms Lagarde is likely to remain consistent with the hawkish stance considering the European economy has surprised to the upside since her final stand of 2022 and expectations of where interest rates will end in this hiking cycle have moved lower, along with downward surprises on gas prices.

Attention is also expected to shift towards the details of the Quantitative Tightening program. Indeed the winding down of the balance sheet has the potential to raise some eyebrows. With the ECB having announced a pace of tightening of €15bn per month to begin with, but yet to announce how this will affect the different bond market segments (the ECB has purchased government bonds, corporate bonds and covered bonds) and the different issuers (a wide variety of countries with differing economic realities), questions need to be answered.

US Federal Reserve

In the US, the expected level the Fed will bring interest rates to (a.k.a. the terminal rate) has been stubbornly stable, hovering around 5% since last November when core inflation finally started to roll over. Indeed, the Fed being more data dependent means all eyes will be on the numbers published and most notably on the impending Employment Cost Index (ECI) which provides a more reliable and comprehensive assessment of wage dynamics and hence, core inflation dynamics.

As such, our expectations for the 1 February FOMC meeting derive from our own forecasts for the ECI (published on Tuesday 31 January).

Our analysis points at the ECI coming out at +1.2% for the fourth quarter of 2022 (i.e. +4.9% on a year- on-year basis, lower than the 5% of Q3-2022 which was already lower than Q2-2022).

While such a print does point at a decelerating wage inflation dynamic, and hence lesser risk of a wage-price spiral, it remains at odds with (or uncomfortably higher than) the 4% level of wage inflation suggested by the recently published average hourly earnings.  

In light of this, the latest publications in headline inflation and hard economic data also surprising on the downside, the disinflation trend is vindicated. This means the Fed should hike at a slower pace from now on and proceed next week with a “normal” hike of 25 basis points, bringing Fed Funds on the edge of the terminal rate finish line. And the persistence in wage inflation implies that deposit rates will either be brought higher than generally expected or that deposit rates will be maintained at the terminal level for longer than expected.

Implication for fixed income markets

While the coming Fed meeting leaves little room for surprise. The March and June meeting could see two additional 25 basis points hike (i.e. more than what is priced in today). Likewise in the Euro Area, the risk on short-term interest rates is tilted on the upside.

Conversely, yields on longer-term maturities could move lower. Indeed they have regained their protective value, with real interest rates being back in positive territories, and an increasing amount of good news being factored in.