The task facing central banks in the coming months will not be an easy one. With a new round of policy meetings just a week away, experts point out that inflation risks are rising on the one hand, while growth forecasts continue to be revised downward on the other. Markets are pricing in interest rate hikes in both Europe and the United States; however, uncertainty regarding the duration of the reopening of the Strait of Hormuz is adding skepticism around those expectations.
What is clear is that markets are being driven by shifts in interest rate expectations and geopolitical developments, with tensions between the United States and Iran adding further volatility.
“Fixed income rallied as moderating inflation and central bank signals reinforced a more cautious monetary policy outlook. Equities remained resilient, supported by strong corporate earnings, particularly in the technology sector. The U.S. dollar remained firm thanks to the Federal Reserve’s relatively hawkish stance, while weaker European data weighed on the euro. Overall, interest rate expectations continue to dominate performance across asset classes,” explain analysts at Union Bancaire Privée (UBP).
The Impact of Hormuz and Iran
According to Raphael Olszyna-Marzys, International Economist at J. Safra Sarasin Sustainable AM, interest rates have shown a very close correlation with oil prices.
“The longer crude oil prices remain elevated, the greater the likelihood of second-round effects emerging. This is precisely the scenario central banks want to avoid, and their messaging has been clearly hawkish since the conflict began. In fact, they have been successful: market-based inflation expectations remain well anchored, especially at the longer end of the curve,” he explains.
This environment implies that much of the rise in bond yields reflects an increase in real interest rates. According to Olszyna-Marzys, if all other factors remain unchanged, this increase represents a tightening of financial conditions. As a result, it will weigh on growth and labor markets, in addition to the direct impact of higher energy prices.
“Central banks face a delicate balancing act: if they do not act decisively enough, inflation expectations could rise again; if they tighten too aggressively, the economy could slow more than necessary,” warns the expert from J. Safra Sarasin Sustainable AM.
For Olszyna-Marzys, market expectations for interest rate hikes are excessive, particularly given that investors are pricing in three additional hikes by the European Central Bank (ECB) before year-end.
“As a result, we expect some decline in yields once energy prices retreat. That decline will likely follow some form of agreement between the United States and Iran,” he notes.
A Broader Perspective
Against this backdrop, what can be expected from the major central banks?
For François Rimeu, Senior Strategist at Crédit Mutuel Asset Management, an objective reading of current U.S. data suggests that a near-term increase in interest rates could be justified.
“In our view, risks currently appear greater in U.S. interest rates than in eurozone rates, which could ultimately support further appreciation of the U.S. dollar against the euro. Naturally, much will depend on developments in the conflict with Iran and commodity prices. But absent significant improvement in the coming months, Mr. Warsh’s task appears particularly challenging,” says Rimeu.
David Rees, Head of Global Economics at Schroders, agrees that a rapid and lasting resolution to the conflict in the Middle East would eliminate significant tail risks. However, he argues that the damage already caused by higher commodity prices and supply chain disruptions appears to have pushed the global economy toward a more stagflationary direction that markets may not yet have fully priced in.
“We doubt that growth will prove resilient enough to force the hawkish central banks of Europe and the United Kingdom to raise interest rates. For the same reason, the rate cuts that markets had expected this year in the United States also appear unlikely to materialize,” argues Rees.
Regarding Asia, Rees notes that Japan should benefit from fiscal stimulus and robust wage growth.
“This, together with higher energy costs and a weaker currency, will keep inflation above target. As a result, the Bank of Japan is likely to continue moving forward with a gradual normalization of monetary policy,” he says.
He also notes that optimism surrounding growth and emerging price pressures has fueled hopes that the Chinese economy may finally emerge from three years of deflation.
“China could export supply-side price pressures and add further upside to global goods inflation. However, the continued collapse of the property sector suggests that hopes for sustained domestic reflation will ultimately be disappointed. The macroeconomic backdrop has already begun to weigh once again on equity markets and could, over time, also limit appreciation of the renminbi,” he adds.
