Articles
5 August 2022

Rates Spark: Hiking into the gloom

The Bank of England hiked while forecasting a recession, shedding a harsh light on central banks' optimism in achieving soft landings. Markets will decide after today's US jobs data how believable the Fed's latest hawkish pushback is. A sense of topping in job creation and next week's inflation may not be enough to end the curve-flattening mode just yet 

Jobs data will test the credibility of the Fed's latest pushback

Fed officials continue to push against any notion of losing their inflation-fighting focus. Further substantial hikes are still needed even after the cumulative 225bp tightening thus far. But it appears that the hawkish Fed talk is losing its reach out the yield curve with the 2Y-10Y UST curve now inverted by more than 35bp.

Fed talk is losing its reach out the yield curve

Markets will judge the hawkish Fed talk against the backdrop of data, one of the key inputs being today’s jobs data. Judging by the 250k consensus job creation – while slowing – may remain strong enough to allow the Fed to keep lifting rates at a fast clip. But note a relatively wide dispersion of forecasts for the payrolls figure with anything between 50k and 325k deemed possible. The risks in the release appear skewed to the downside and there is a lingering sense of having topped out in the data. That is how we would read a 10Y yield struggling to put more distance to the 2.5% level.

Of course, next week’s inflation data will still very likely show prices rising much faster than desired. A likely drop in the headline rate amid falling gas prices should provide some relief and add to the sense of topping out, though especially the core rate will continue to signal that the Fed’s job is far from being done. That could keep the curve in a flattening mode for now.

The BoE hiked 50bp while forecasting a recession

US data holding up for now, and unemployment still falling may give the Fed room for its hawkishness. But it is the Bank of England yesterday that has shed a harsh light on central banks’ optimistic notions that soft landings are possible, even if difficult.

Curve flattening was symptomatic of the broader backdrop where recession fears dominate

The BoE delivered a larger (by its standards) 50bp hike yesterday. The market’s reaction to the BoE was symptomatic of the broader backdrop where recession fears have come to dominate, with the effect of flattening yield curves. In fact, the 2Y-10Y Gilt curve briefly inverted for the first time since 2019 around the BoE decision.

The BoE itself forecasts a long recession by late this year and inflation falling below target later in 2024. As our economist points out, hiking in the face of such an outlook underscores how concerned the Bank is about current inflation dynamics and also indicates a willingness to sacrifice growth in order to get inflation under control.

Crucially, that forecast is premised on the Bank rate peaking at 3% as was implied by markets. It is a hint that market pricing of further tightening remains too aggressive. While the BoE itself reiterated its willingness to act ‘forcefully’ to curb inflation, the window to deliver more hikes is closing quickly. The next hike in September, even if possibly another 50bp increase, could also be the BoE’s last before hitting the pause button on the hiking cycle.

By the end of the day, the Sterling Overnight Index Average curve still stood roughly 10bp below the previous day’s close for the period late 2023 and beyond. But SONIA is still seen peaking close to 2.9% in early 2023, which leaves room for more downside correction.

Today’s events and market view

Following yesterday's BoE decision, US markets should move back into the driving seat. The US job data takes the spotlight today. Markets will judge the credibility of the recent Fed pushback again on the strength of the labour market. While consensus is looking for a 250K increase in payrolls, the individual forecasts are widespread between 50k and 325k pointing to downside risks in today's release. In any case, our economists suspect that it will still be a lack of supply that holds back the payrolls increase.

The curve may stay in flattening mode, nonetheless, as markets will already eye next week’s inflation data. The Fed’s communication may lose its reach out the curve, but the grip on the front end remains relatively firm for now.

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