The tale of two banks

Comments by Franck Dixmier, Global CIO Fixed Income at Allianz Global Investors, ahead of the FOMC meeting on 14 & 15 December, and the ECB meeting on 16 December 2021.

The tale of two banks

The?monetary policies of the US Federal Reserve (Fed) and the European Central Bank (ECB) have been completely aligned since the outbreak of the health crisis, but we expect a desynchronisation between the two in 2022. They are operating now in different environments. In terms of inflation, growth and the health crisis, the United States and euro zone are no longer in the same boat. Consider the normalisation of their monetary policies: the Fed will likely accelerate normalisation in light of inflation that is no longer considered transitory, but the process should be much more gradual for the ECB. Moreover, the differences in interest rates set by the two central banks will likely increase.

The Fed changes course

?Key takeaways

• At the Federal Open Market Committee (FOMC) meeting on 14 and 15 December, we expect the Fed to announce an acceleration in the pace of tapering, which could be completed as early as March 2022.
• This meeting will also be an opportunity for the Fed to communicate its new growth and inflation forecasts, with an expected upward revision of the latter. The Fed’s “dots” could also be revised to higher levels, in line with those anticipated by the markets (ie, three rate hikes in 2022 and three additional hikes in 2023).
• Investors are prepared for a more hawkish Fed, as evidenced by the significant decline in inflation expectations and higher short-term rate hike expectations, but they should expect more volatility.

In a matter of months, the tone within the Fed has changed markedly, reflecting a shift towards a faster-than-expected tightening of monetary policy.

For months, the Fed had been preparing the markets for a very gradual tightening of monetary policy. The focus had been more on the objective of full employment – especially among minorities – than on price stability. This strategy is no longer appropriate. The strength of inflation, which has continued to surprise on the upside in recent months (reaching 6.8%?in November), is forcing a radical shift in the conduct of US monetary policy.

?Fed Chairman Jerome Powell's speech at his recent Senate hearing put an end to the Fed’s confused message, which resulted from its difficulty characterising the resurgence of inflation. The term "transitory" is no longer appropriate to describe rising prices. Mr Powell also used the question-and-answer session to clarify that an acceleration of tapering, with an end to asset purchases a few months earlier than expected, would be appropriate.

No doubt that the recent tension in inflation expectations, which peaked in mid-November (with the US break-even 5-year at 3.20% at its highest), had an influence on his wish to accelerate the timetable. With wages continuing to rise and the threat of a price-wage loop, the Fed cannot run the risk of inflation expectations slipping upwards, which could lead to a much stronger action than necessary.

The Fed therefore finally seems ready to clarify a line of conduct that seemed unclear and unsuited to the reality of high inflation. Inflation has not yet reached its peak, which we expect to occur in the first quarter of 2022.

?We think it is healthy for the Fed to leave itself some room for manoeuvre, so that it has complete freedom to raise rates if necessary, without locking itself into forward guidance that is too restrictive.

?The FOMC meeting should not confuse investors, who seem ready for the Fed to tighten its stance. The significant decline in inflation expectations and higher expectations of short-term rate hikes reflect investors’ confidence in a more aggressive Fed that is decidedly less "behind the curve" than it claimed a short while ago. However, investors should expect more volatility. In fact, long-term rates are facing headwinds, with a more restrictive monetary policy on the one hand, and increased uncertainty linked to the Covid-19 pandemic and geopolitical tensions (particularly with regard to China and Russia) on the other. This is evidenced by the high market volatility, albeit in a narrow range, seen in recent weeks. In the medium term, our scenario assumes a moderate rise in long-term rates. But given the context, this should take time to materialise.

ECB stays the course, but adjusts its monetary policy

?Key takeaways

• We expect confirmation of the end of the Pandemic Emergency Purchase Programme (PEPP), with tapering by the end of March 2022 and an upward calibration of monthly purchases under the asset purchase programme (APP).
• Unlike in the US, we expect no news from the ECB on rates?– particularly while the ECB continues to analyse the transitional inflation peak.
• Investors, whose expectations are well anchored, should remain calm, but spread volatility will likely increase.

In September, ECB President Christine Lagarde announced that the decision on a possible start of a gradual normalisation of monetary policy would be taken in December, given that the PEPP expires at the end of March 2022. The ECB's monetary policy committee meeting on 16 December is therefore particularly eagerly awaited.

Of course, the environment remains difficult to analyse. The health crisis is mounting again, but despite the increase in contaminations, the news is reassuring regarding the danger of the new variant. Furthermore, inflation figures continue to surprise on the upside, especially in Germany (5.2% in November). However, unlike the Fed, the ECB continues to analyse inflation as transitory, in line with the consensus among economists. In the euro zone, core inflation reached 4.9% in November, but core CPI is at 2.6%, well below the US, and no price/wage spiral is observed. The ECB therefore expects inflation to be below its 2% target by the end of 2022.

Given this analysis, at the next meeting the ECB should give details on a new stage of its monetary policy, which it had characterised as "forceful and persistent". We therefore expect the central bank to communicate the need to maintain its voluntary monetary policy to continue supporting the economy and achieve its medium-term inflation target of 2%. Ms Lagarde should also insist on keeping flexible tools to ensure the proper transmission of monetary policy and to avoid any risk of financial fragmentation, but also to keep wide margins of manoeuvre. It is likely that Ms Lagarde does not want to commit herself for the long term, given the current inflation spike and the tensions within the Governing Council.

We are therefore expecting the confirmation of the end of the PEPP, implemented in March 2020, with tapering until March 2022. On the other hand, the ECB is expected to announce a temporary increase in the "historic" APP, with an increase in the monthly volume of securities purchases from the current EUR 20 billion to approximately EUR 40 billion. Faced with an APP whose criteria are restrictive (in terms of the allocation key and maximum debt held by a country), flexibility should come from reinvestments of PEPP amounts, in excess of EUR 300 billion in 2022 and 2023, and from the recalibration of APP.

It will also be interesting to see, for the first time, the economic forecasts out to 2024. On the other hand, we do not expect any announcement of an increase in interest rates – a scenario well-anticipated by the markets, which only envisage an?increase of 25 basis points by December 2023.

Investors who adhere to the analysis of the temporary nature of inflation – as shown by inflation expectations such as the 5-year/5-year forward rate, which peaked in October but fell back to 1.86% – should remain calm. We expect more volatility in periphery spreads and credit, but no major divergence as the ECB, although less present in the markets, should remain vigilant and ready to intervene.

We are entering a fully assumed phase of desynchronisation of US and European monetary policies, with an upward pressure on the US dollar that should not displease the ECB.

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