Rates Spark: More divergence between US and European rates

Both the Federal Reserve and Bank of England hiked rates this week, but the tone that the central banks have struck was quite different. While the Fed had surprised with an aggressive dot plot and brushed aside fears of recession, the BoE struck a decidedly more cautious note yesterday.

Not only was the BoE's split of votes a sign of greater caution – it was split 8-1 with one vote for keeping rates on hold. The MPC was also concerned about the future hit to spending from higher energy prices. Premised on the market’s pricing of hikes going into the meeting the BoE forecast that inflation would now fall below the 2% target within the forecast horizon.

Market pricing remains aggressive with overnight rates seen just shy of 2% by year-end

The sterling curve has already reacted with front-end rates dropping sharply in the wake of the meeting with the 2y SONIA swap almost 20bp down on the day. The 10Y rate was down 8bp, effectively steepening the curve. Money market pricing remains aggressive though as overnight rates are still seen just shy of 2% by year-end – at the moment our economists see only one more hike this year. The market’s scepticism about the growth outlook remains confined to the continued inversion of the yield curve.

The European Central Bank had similarly struck a more cautious tone last week, even if it progressed further on its path to policy normalisation. At the ECB watchers conference, executive board member Isabel Schnabel echoed this tone, highlighting that “fossilflation” – acute amid the geopolitical situation – and “climateflation” were adverse supply shocks that required a more finely balanced strategy as the monetary policy trade-off implies that the central bank cannot stabilise growth and inflation at the same time.

With no signs of de-anchoring inflation expectations, the ECB can allow itself a gradual approach to policy normalisation for now. Once inflation drivers turn toward “greenflation” however – ie, investment and demand-driven price pressures – then it will be put into the position of stabilising output and inflation simultaneously. It gels with ECB President Christine Lagarde stressing last week that the Bank had indeed not accelerated the normalisation process.

Gradualism notwithstanding, there is still little in the way of overshooting on hike expectations

But then there are voices of those like Dutch central bank’s Klaas Knot, stressing that inflation remains the dominant worry. He would not rule out two hikes this year and saw no need for making only small 10bp hikes. Gradualism notwithstanding, this suggests that there is still little in the way of markets overshooting on their hike expectations for now. Obviously, the war is adding noise, but it also magnifies worries over whether the eurozone economy will withstand a higher rates regime – here as well we think it should mainly manifest itself in the flattening pressure on yield curves.