Aegon AM: Fed, ECB and BoE – central banks diverging despite facing the same problem

20 juli 2022

The Fed, ECB and Bank of England are all now on diverging paths, despite facing similar problems – with clear differences in policy choices emerging according to Aegon Asset Management.

Sandra Holdsworth, head of rates at Aegon AM, says the Fed is letting inflation “tax” consumers to dampen demand and is achieving this. The ECB, meanwhile, appears ready to support markets while the Bank of England will undershoot market expectations on rates.

“The last few months major central banks have taken centre stage in financial markets. Policy is shifting from very accommodative, on the back of the coronavirus impact, to more restrictive, driven by mounting inflation worries. It remains to be seen how inflation will behave in the coming months, but there are signs the ‘tax’ being imposed on consumers via higher food and energy prices is taking a toll on spending behaviour,” Holdsworth says.

“Similarly, the sharp upward rise in US mortgage rates is likely to curtail further home price appreciation. Ultimately, this is what the FOMC wants to accomplish, specifically bringing aggregate demand more in-line with available supply,” she added.

Holdsworth argues that, because monetary policy is a blunt instrument with long and variable lags, the risk of a Fed-led recession remains quite high and may have even grown with the FOMC’s recent 75bps hike. As a result, with most central banks in a similar tightening/inflation-fighting regime, this economic slowdown could very well be global in nature.

“Ultimately, we believe the FOMC will be successful in reducing aggregate demand, with some type of recessionary impulse likely in 2023. This will likely force the Fed to pivot to bring federal funds to more normal levels, with US Treasuries the likely beneficiaries of such a shift in policy,” Holdsworth says.

Of the ECB, Holdsworth sees the overall shift to normalisation of monetary policy and its recent acceleration as a signal that the ECB is concerned with the high level of inflation. But Holdsworth warns that targeting lower yields in high-debt nations could trigger political trouble for the EU bloc, with markets convinced the ECB will act if spreads widen further.

“The spread between Italy and Germany has tightened by almost 30bps, with the 10-year spread being traded at around 207bps. Bond markets seem to be convinced that the ECB will step in if the spread widens any further. However, the spread reduction will do nothing to diminish the overall increase in yields which is needed to reduce higher inflation. The ECB has put itself in a tough spot, whereby tighter monetary policy is required to combat higher inflation. This could, however, also lead to a fragmentation in eurozone yields and higher interest rates for periphery countries that already face large debt burdens. Targeting lower yields for countries with high debt burdens could lead to significant political and legal battles, as the monetary policy of the ECB is meant to be done proportionally for each country.”

Finally, the Bank of England appears to be moving steadily along despite some fairly dire economic warnings for the UK economy. The central reason for this is the BoE sees inflation as a global - not local - phenomenon.

For this reason, Holdsworth says the Aegon Asset Management view is that the BoE will keep interest rates well below market expectations.

Holdsworth adds: “The Bank of England (BoE) continues to raise interest rates, with rates reaching 1.25% in June. It remains concerned about inflation which the MPC perceives as predominantly being a global rather than a domestic issue, although they are concerned about the tightness of the UK labour market. Over the longer term, it expects weakness in the UK economy as a result of the reduction in real income levels and the effect that will have on the consumer side of the economy. Over the medium term, the BoE expects inflation to return to target levels as the current supply and energy shocks to the global economy pass. At this stage, we expect interest rates to peak in the UK around 1.50%, well below the current levels of market pricing.”