Fed and ECB: expected rate hikes will not necessarily be the last ones

Comments by Franck Dixmier , Global CIO Fixed Income at AllianzGI, ahead of the FOMC meeting on 25-26 July and ECB meetings on 27 July 2023

Fed: toward a dovish hike

We expect the US Federal Reserve (Fed) to announce a 25bp rate hike at the Federal Open Market Committee (FOMC) meeting on Wednesday.

• Despite reassuring data on the economy, notably a fall in inflation, the battle is not yet won and a further adjustment cannot be ruled out.
• This hike should come as no surprise to the markets.

Recent US economic data has finally been reassuring for the Fed. The recent fall in total and underlying inflation is good news. In June, the consumer price index (CPI) came in at +3%[1] compared to +4% for the previous month – a spectacular slowdown. Core CPI inflation also fell to 4.8% from 5.3% in May. A deceleration in retail sales growth, which came in at just 0.2% in June against expectations of 0.5%, and a less tight labour market, should help to consolidate this downward trend in inflation.

Despite this backdrop, we believe the Fed will raise its key rate by 25bp. In fact, it is too early for the central bank to claim victory. Households' one-year inflation expectations rose slightly to +3.4%[2] in July from +3.3% in June, and three-year expectations also rose slightly to +3.1% in July from +3% in June. That is a warning to the Fed that it must remain vigilant. The Fed cannot take the risk of being surprised by a renewed surge in core inflation that would jeopardise inflation expectations, which have so far remained well anchored. So we cannot rule out a further adjustment in the autumn.

However, we do believe the Fed has almost achieved its objective and should communicate the fact that rates are very close to an appropriate level that is compatible with its price stability target. Keeping interest rates on a high plateau, with total inflation expected to continue to fall and real interest rates rising, should help to tighten monetary conditions and remove the need for the Fed to intervene further.

This 25bp rise is widely expected by investors. After the sharp correction in June, the "higher for longer" theme has finally taken hold in the markets, which are no longer projecting any rate cuts for 2023.?

These healthier market conditions should encourage duration buying on the US yield curve.?

ECB: markets too sanguine on further hikes

• We expect the European Central Bank (ECB) to announce a 25bp rate hike.
• This hike has been perfectly anticipated by the markets and should have little impact.
• More hikes are to be expected, which the markets are not anticipating sufficiently.

The situation in the euro zone is less clear-cut than it is in the US. While headline inflation continues to decelerate in the euro zone (at +5.5%[3] year-on-year in June compared with +6.1% in May), core inflation is holding up well and clinging to high levels (at +5.5% year-on-year in June compared with +5.3% in May). In a context where companies are still benefiting from pricing power, and where low unemployment is not only supporting resilient demand but also fueling wage demands, the risk of core inflation remaining at high levels cannot be ruled out – particularly given the mix of fiscal and monetary policy is not sufficiently restrictive. The power of government stimulus and the excess savings accumulated during the Covid period continue to support demand.

Against this backdrop, the ECB cannot compromise and must continue to tighten financial conditions. Its credibility is at stake, while inflation expectations remain well anchored. In addition, the central bank has retained some room for manoeuvre, since the 400bp increase in key rates since July 2022 has not so far created any risk to financial stability, and governments do not have any refinancing problems.

We therefore expect a 25bp hike at this month’s ECB monetary policy meeting, which should be followed by a similar move in September. The number of hikes will then be calibrated to the trend in core inflation, for which there is currently no reassuring news. At Thursday's meeting the ECB president, Christine Lagarde, is expected to reiterate once again that the ECB will remain more dependent than ever on economic data.

The markets are anticipating the July hike, but they are projecting only one further increase between now and the end of 2023 to reach a terminal deposit rate of 4%. We therefore believe the risk of the ECB continuing to tighten monetary policy beyond 4% is not being taken into account.

This lack of a "margin of safety" means we are cautious on euro rates.

?

[1] US Department of Labor, July 2023

[2] University of Michigan

[3] Eurostat, July 2023

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