The US and EU central banks will communicate their rate decisions this week on respectively Wednesday, 3 May and Thursday, 4 May. Ethenea’s portfolio managers Illia Galka and Volker Schmidt shed their light on what to expect.
Fed: one last round?
After the bankruptcy of California's Silicon Valley Bank (SVB), the Fed's Federal Open Market Committee (FOMC) may have found an unexpected helper in the fight against inflation. Although it has not (yet) led to a major banking crisis, it has tightened conditions in US credit markets. Current indicators suggest that US banks are becoming more restrictive in their lending, with the result that fewer companies want to expand for lack of cheap sources of financing, which in turn contributes to easing inflationary pressures. “This should undoubtedly have made Fed members more confident, so that not so many interest rate steps will be needed to fight inflation. Maybe even just one,” says Illia Galka, Portfolio Manager at Ethenea.
The latest figures on economic development paint a mixed picture. In March, the American economy created 236 000 new jobs, just above expectations. The unemployment rate remained steady at 3.5%, while the labour force participation rate continued to rise to 62.6%. Despite the strong labour market, average US wages rose by only 4.2% year-on-year and a barely measurable 0.1% month-on-month. The consumer price index CPI also rose by a very small 0.1% month-on-month and 5% year-on-year in March, a significant decline from February. In contrast, the core inflation rate, which excludes volatile energy and food prices, rose more than the CPI at 5.6% year-on-year, but was still in line with expectations. Illia Galka: “Going forward, the inflation rate is expected to decline further, but at a level well above the Fed's target. One of the most important signals the economy is sending to central bankers is relatively strong purchases on credit, which suggests that lending has been decent after all so far.”
In addition, a series of statements by various Fed representatives in recent weeks have dispelled almost all feelings of uncertainty. The markets now expect a further rate hike of 25 basis points, which would bring the key interest rate into a range of 5.0% to 5.25%. The market-implied probability of such a rate decision, which is also in line with the Open Market Committee's current forecast, is just under 80%. “From a market perspective, further interest rate steps in the summer are significantly less likely,” says Illia Galka. “Both indicate that the May rate hike could mark the end of the Fed's current rate hike cycle. This seems to be a rare moment of agreement between the Fed and the market. Before, the market did not believe in the Fed's determination to pursue a restrictive monetary policy, just as now it does not believe in the Fed's statements, repeated as if on a continuous loop, not to cut interest rates until the end of 2023. The Fed's rate path implied by the market foresees the first rate cut as early as July, which is far too optimistic in our view. Inflation is still too high, and the Fed has said it is willing not to cut rates even in a milder recession. The US central bank has had many rounds of rate hikes and the US economy is showing the first cautious signs of a slowdown. But Fed members seem to be in the mood for one last round after all.”
ECB: hike of 50 basis points
The ECB wants to make its decisions dependent on current inflation figures and more recent economic data. The last interest rate decision in March 2023 came only a few days after the bankruptcy of Silicon Valley Bank, Credit Suisse wobbled almost at the same time and the distress sale to UBS took place only a few days later. “Today we can say that the impact on the Eurozone economy is negligible,” says Volker Schmidt, Senior Portfolio Manager at Ethenea. “The service sector is humming, as the published sentiment indicators (purchasing managers' indices) have recently confirmed again. In industry, the situation is more differentiated, but here, too, incoming orders are picking up again. The economic condition is at least solid, no reason for the ECB to be cautious. And inflation is still far too high, albeit slightly declining.”
With its latest interest rate decision, the ECB also published its current inflation forecast, which was revised downwards compared to December. The ECB expects inflation to average 5.3 % in 2023 and 2.9 % in 2024. In the short term, falling energy prices and the normalisation of supply chains will help here. A highlight here is the fall in regulated electricity prices in Italy by a staggering 55 % in April 2023, “but this also shows that this broad inflation rate obscures the view of the underlying trend,” adds Volker Schmidt.
Core inflation, excluding the volatile components of energy and food, continues to rise and is approaching the 6 % mark. This should be a clear warning for the central bank that the fight against inflation is far from won. Volker Schmidt: “In our view, a further interest rate hike of 50 basis points would therefore be the right way to raise the deposit rate from the current 3 % to 3.5 % for the time being and still to at least 4 % by the summer break. As inflation for April 2023 was 7%, this will be decisive for the outcome of the interest rate decision.”
Eventually, core inflation and comprehensive inflation will converge. Currently, comprehensive inflation is still higher, but it will certainly fall below core inflation in the coming months, as has already happened in the US. However, since energy prices will not fall permanently, the two values must converge by 2024. Volker Schmidt: “We expect this to be 4% or higher, well above the ECB's forecast for 2024. The ECB will still have to make some uncomfortable interest rate decisions.”
