Rising inflation forced advanced economies to raise borrowing costs by a total of 25.15 percentage points in this cycle, the most aggressive in decades.
So it is not surprising that signs that central banks in the US, the Eurozone and Britain will follow the smaller countries and that the pace has slowed have led to relief. US stocks are up 13% from their October lows; 10-year Treasury yields fell 0.38 percentage points, or 38 basis points, in November, the most since March 2020.
However, markets still expect the Fed to raise interest rates by more than 100 basis points to 5% in the second quarter of next year. The European Central Bank, which has raised interest rates by 200 basis points since July, is expected to double the deposit rate to nearly 3% by mid-2023.
With inflation likely to peak and a recession looming, the risk of a severe tightening to accelerate economic downturn is on investors’ wish lists for the coming year.
“We’re past the point of a major (Fed) policy blunder, and we think they made it,” said Robert Waldner, head of macro research at $1.3 trillion asset manager Invesco.
“They were very aggressive. They raised the prices a lot in a very short period of time.”
The Fed’s recent research suggests that the bank has overdone what is generally required by policies and should target 3.52%, as opposed to the 3.75%-4% it currently targets.
Waldner said he would recommend a slower pace of tightening than markets expect. Already, tariffs are restricting, inflation has peaked and growth is slowing, he said.
Oil prices, which have fallen 45% since February, have wiped out the 2022 gains. Natural gas prices in Europe are still high, but they are about 60% below their September peak.
Supply chain disruptions have abated and producer prices are moderating or declining. The ABN AMRO Global Bottlenecks Index returned to neutral in November for the first time since the end of 2020.
The latest inflation figures from the US and the Eurozone fell more than expected.
Yes, economic growth figures generally held up better than expected.
However, the British economy contracted in the quarter ending in September, putting the country on the brink of a prolonged recession, manufacturing in the United States contracted, and business data point to a moderate recession in the eurozone. According to a Reuters poll, the probability of a recession in the United States next year is 60%, up from 25% in June.
Graph: global economic activity blinking red, https://www.reuters.com/graphics/GLOBAL-ECONOMY/byprllommpe/chart.png during delays
Thomas Kosterge, chief economist at Pictet Wealth Management in the US, is concerned about the gap between forward-looking indicators pointing to an economic slowdown and the strength of labor markets, which the Fed wants to weaken.
US mortgage rates have doubled this year and applications are down about 40%. Home sales are falling faster than in previous tightening cycles, according to alternative asset manager Apollo.
Research by the Fed, which takes into account mortgage premiums and corporate borrowing costs, found that financial conditions actually reversed the equivalent of a policy rate of 5.25% in September.
“The Fed is still focused on past data. I’m afraid the Fed is not taking into account the slowdown in its monetary policy,” Kosterge said.
Research by the Organization for Economic Co-operation and Development has also shown that all advanced economies that raise interest rates at the same time hurt growth the most and have the least impact on lowering inflation.
“The Fed is dangerously underestimating what will happen to the US economy if the global economy goes into recession,” said Claudia Sahm, former Fed economist.
In the eurozone, rising energy prices and supply constraints have fueled inflation so much, some say the European Central Bank is going too fast because its hikes hardly relieve those pressures.
Hard-line policymakers stress the need to avoid a spiral of wages and their prices, but admit that there are no indications of such a spiral with wages increasing by about 4% this year against inflation of 10%.
Graph: Will the ECB slow down? https://www.reuters.com/graphics/EUROZONE-MARKETS/ECB/mopaknxbjpa/chart.png The ECB also said that the expected recession would likely not be enough to contain inflation.
This opens the door to a more difficult downturn without making it clear how big the recession is to curb inflation, according to the ECB, former chief economist of the European Central Bank Peter Bright told Reuters.
“What they have done so far is good in principle, but the risk of error has not gone away,” he said.
Both short-term US and German bonds are yielding much more than long-term bonds, which is a sign that markets suspect that monetary policy will exacerbate the economic pain. The excess yield on 2-year 10-year US bonds was the highest recently since the early 1980s.
According to Erik Nielsen, Chief Economic Adviser at UniCredit, the European Central Bank should take a break.
“My real concern is 2023-24, when this year’s monetary policy tightening will have the maximum impact on demand and will act as an amplification of the pain experienced by households and businesses from higher energy prices … much like the bulk of the fiscal support,” he said in a note. Graph: The US yield curve is strongly inverted, https://fingfx.thomsonreuters.com/gfx/mkt/mopakknxwpa/YCDEC.PNG
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