Forget a year-end financial market rally. The message from the world’s leading central banks is unmistakable: the fight against inflation is far from over.
On Wednesday and Thursday, the U.S., eurozone, British, and Swiss central banks convened and halted the pace of aggressive rate hikes.
However, their signals were not what markets, which have surged strongly in recent weeks on the idea of peak inflation and peak interest rates, expected to hear.
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Christine Lagarde, president of the European Central Bank, stated that further 50-basis-point rate hikes are forthcoming and that the ECB has not yet “pivoted.”
It raised rates by 50 basis points on Thursday, following two consecutive 75-basis-point rate hikes to combat double-digit inflation.
The market for government bonds took a beating. Yields on interest rate-sensitive two-year German bonds increased by 24 basis points, the largest one-day increase since 2008.
Italian borrowing prices rose about 30 basis points to 4.13 percent, while European equities fell nearly 3 percent and Wall Street stocks fell 2 percent.
Antoine Lesne, head of EMEA strategy and research for State Street (NYSE:STTSPDR)’s ETF division, remarked, “The reaction on European bond markets has been savage.”
A tiny decline in inflation in the euro area in November, to an annual rate of 10%, prompted market speculation that the ECB could abandon its campaign against skyrocketing prices.
“The market had gotten ahead of itself about the eurozone in recent weeks,” said Lesne. “Now, they’re repricing the idea that the ECB will have to remain hawkish.”
Ed Hutchings, head of rates at Aviva (LON:AV) Investors, stated that he anticipates peripheral European bonds to “struggle” and European bonds to be considerably less supported in the future.
TOO COMFORTABLE?
In the meanwhile, Federal Reserve Chairman Jerome Powell cautioned on Wednesday that recent indications that U.S. inflation may be decreasing have not yet inspired confidence that the battle has been won.
“Forget the Santa rally. The Fed looks more like the Grinch this Christmas,” said Titan Asset Management’s chief investment officer, John Leiper.
The S&P 500 reached its lowest level in a month on Thursday. On Tuesday, the index rose as much as 2.76 percent to a three-month high as an unexpectedly modest increase in consumer price inflation bolstered expectations that the Federal Reserve may soon reduce its rate hikes. This year, the S&P has lost more than 16%.
After a 50 basis point increase, Switzerland’s central bank governor, Thomas Jordan, stated that it was too early to “sound the all-clear” on inflation.
Hetal Mehta, senior European economist at Legal & General Investment Management, stated, “It feels as though the main central banks, including the Fed, are fighting a market narrative of satisfaction that we’ve reached peak rates.”
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Recent statistics indicating a minor decline in inflation in the United States and Europe caused bond rates to retreat from multi-year highs and the S&P 500 to gain nearly 10% from its October low.
While 10-year U.S. Treasury rates are still projected to conclude the year up 200 basis points, they are expected to experience their largest quarterly decline since the beginning of 2020. German benchmark Bund rates are also up 200 basis points over 2022 but are nearly 50 basis points below October’s multi-year peak of 2.5%.
Such abrupt adjustments undermine the very financial conditions that central banks are attempting to tighten to prevent inflation.
During Thursday’s post-decision news conference, Lagarde of the ECB mentioned funding conditions and stated that further tightening was necessary.
Mehta stated, “A market rally would represent an easing of financial conditions, which contradicts the notion that they (policymakers) need to move interest rates into a restrictive area.”
