For more on our views for 2022, please see “Outlook 2022: Flying at a Lower Altitude,” Cambridge Associates LLC, December 2021.
This week, the Federal Reserve, the Bank of England, and to a lesser extent the European Central Bank all acted to tighten monetary policies. These tightenings came as inflationary pressures have surged in many countries and as other central banks have looked to rein in stimulative policies. But, when combined with above-trend growth expectations next year and central banks’ likely cautious tightening approach, we suspect financial conditions will likely remain accommodative and supportive of risk assets.
The Fed left its policy target range unchanged at 0–0.25% on Wednesday but indicated it would double the pace at which it reduces its $120 billion per month asset purchase program, from $15 billion to $30 billion, putting it on track to conclude in March. A faster taper gives the Fed the flexibility to increase policy rates sooner, if, for example, inflation is higher-than-expected. The Fed’s updated Summary of Economic Projections showed that most Fed officials now expect three policy rate hikes in 2022.
Today, the BOE became the first major developed markets central bank to raise interest rates in this cycle, increasing its base rate by 15 basis points to 0.25%. Though the emergence of the Omicron variant of COVID-19 has added uncertainty, policymakers are focused on the growing underlying inflationary pressures in the economy.
Meanwhile, the ECB left its main deposit rate unchanged at -0.5% but outlined that it will begin gradually tapering its asset purchases next year. After March 2022, total monthly net asset purchases will decline from about €80 billion to €20 billion by October 2022, with purchases remaining open-ended thereafter. With the ECB expecting to end net purchases before raising rates, a hike next year remains unlikely.
Equities rallied following the announcements, while the initial impact on treasury markets was more muted, especially in the United States, where the new Fed projections were more in line with pre-existing market pricing. The BOE move was less expected, resulting in gilt yields across the curve initially spiking up to 10 bps higher then settling 2–3 bps higher. Peripheral European bond spreads widened modestly on news of the ECB decision.
In recent months, short rates have moved higher as markets have pre-emptively priced in more aggressive tightening by central banks. The policy-sensitive two-year US and UK Treasury yields have increased 41 bps and 25 bps, respectively, in the fourth quarter. While short rates have moved higher, longer rates have been flat or declined. This indicates the market may be skeptical of how many rate hikes can be delivered before the impact on growth forces a pause or a reversal. As it is, central banks themselves are forecasting a relatively shallow rate hike cycle. For example, the Fed expects it will only need to increase policy rates by roughly 200 bps to 2.1% by the end of 2024. This suggests policy rates will remain well below the Fed’s terminal rate of 2.5% for the foreseeable future despite above-trend growth and inflation.
A shift in policy and the withdrawal of stimulus increases uncertainty and raises the prospects for higher volatility. Indeed, the ICE BofAML MOVE Index and CBOE Volatility Index measures of bond and equity market volatility have both moved higher in recent months. However, given financial conditions will likely remain accommodative next year, the risk of a policy-induced correction appears low. The biggest risk is higher-than-expected inflation, which could prompt central banks to tighten policy faster-than-anticipated.
TJ Scavone, Investment Director, Capital Markets Research
Thomas O’Mahony, Investment Director, Capital Markets Research