Rates Spark: Expectation management

Markets continue to take the glass-half-full approach to the situation in the Middle East. One could easily argue that valuations start to look vulnerable here. After all, some market segments have already fully retraced the drawdowns caused by the turmoil. At the same time, the Strait of Hormuz remains effectively closed for now. As time passes and expectations are not met, real knock-on effects could start to be felt clearly – after all, economies are living off reserves. In the background are stories such as the IEA warning that European airlines have maybe six weeks before they run out of jet fuel, or the IMF again warning that the economic damage is being underestimated.

The ECB minutes, meanwhile, confirmed the central bank’s hawkish shift. Still, it was signalled again that there is unlikely to be enough data available at the upcoming meeting in two weeks' time to change the policy stance. Market pricing for the April meeting has continued to slide, with only 3bp of tightening now in the forward rate. With an implied probability of just over 10%, an April hike scenario has effectively been reduced to a tail risk.

Further out though, the market pricing did bounce off from a low of seeing just 50bp of tightening by year-end. For one, oil prices have moved a little higher towards US$100/bbl again. But we also think the significance of the 50bp might rest on the 'one is none' narrative. While this is a fair assumption in the sense that you want a policy shift to be effective, our own revised base case scenario actually sees only one rate hike. Of course, this remains highly path-dependent on the energy situation, but we think it is a plausible scenario if one views the ECB’s strategy through the lens of expectations management and the ECB’s concerns around the credibility of its reaction function.

We think rates markets are right not to look through the inflation story as readily as some other market segments. Keep in mind that the containment of longer rates, absent a notable rise in growth concerns, is premised on the reaction function that the market is pricing on the front end. That is a delicate balance the ECB needs to manage, and also leaves the long end still prone to temporary rises.