Tightening to continue, despite Ukraine invasion complications

Rates to rise further in 2022; Quantitative tightening begins in March

The advent of serious conflict in the Ukraine is clearly going to have an impact on the macro-economy, although the extent of that depends upon the scale of that conflict. To recap: the Bank of England (BoE) increased interest rates by 0.25 percentage points to 0.5% in February, with four out of nine rate-setters pushing for a higher increase of 0.5 percentage points. Along with higher borrowing costs, rates hitting 0.5% has triggered the process of quantitative tightening (QT). This initial phase of QT will involve the BoE not re-investing the proceeds from maturing assets in its Asset Purchase Programme, most immediately the £25bn of gilts set to mature on 7 March. It’s estimated that the impact of this rise will be equivalent to a 30 bp rise in interest rates. This QT marks the start of a process which is projected to see over one-fifth of the Bank’s bond holdings being wound down by the end of 2025 (see Figure 1). At this stage we expect this process to continue despite the conflict in Ukraine, as inflationary pressures rising and our hawkish stance is supported by reading into the BoE’s guidance, reiterated in Feb, that once rates hit 1% it will consider accelerating QT by actively selling off its bond holdings. Beyond that we expect that rates will rise to 1% in June, although with uncertainties surrounding the impact of QT – including impact on broader asset prices – we also expect the Bank of England to proceed cautiously and for rates to rise to 1.25% in early 2023.

Significant portions of the present inflationary spike are transitory, but regaining the 2% target remains uncertain

The BoE’s latest estimate is that inflation will peak at 7.25% in April when the lifting of the energy price cap and tax rises kick in; our view had been that inflation would end up being closer to 8%. With energy prices now surging in response to the Ukrainian crisis any hoped for or anticipated easing of energy prices looks to be some way off. The full impact will have to be assessed in the coming days, but the prolonging of the energy price spike makes the spill over from energy to the broader economy a good deal more likely than anticipated and core inflation is already at 4.4%.  While the UK does not directly import a significant amount of gas from Russia, consumers will of course still feel the impact of from higher global oil and gas prices arising from a prolonged conflict.

Growth in business investment, key to the UK’s recovery, is likely to be delayed by Ukraine crisis

Economic output has now regained its pre-pandemic level, despite seeing a fall in December due to omicron. However, there were always a number of uncertainties: upcoming tax and inflation pressures in April were already set to suppress consumer spending and we can now add in an additional layer of geo-political concerns. While overall gross fixed capital formation is around its pre-pandemic level, the business investment component remains subdued at around 8% below its pre-crisis level (see Figure 2). Incentivised by measures such as the super deduction – which will give companies investing in new plant and machinery a 130% capital allowance – our projection had been that businesses would start to deploy much of their accumulated savings into the UK economy, helping to drive GDP growth over the next year. It now seems much more plausible that this investment is delayed until later in 2022 when there is likely to be greater clarity on the exact scale of the Ukrainian crisis and its wider impacts. 

Hawkish rhetoric rattles rates

The volatile start to the year in the rates market has only exacerbated further in February as central banks globally pivot towards a more hawkish stance. In January’s Rate Wrap we highlighted the Federal Reserve’s move to prepare the market for a rate hike in March, but left the future path rather open, and this has been followed this month by a surprise 5-4 decision from the Bank of England where the four dissenters wanted to increase rates by 0.5%. However the biggest surprise came from the European Central Bank (ECB), which for the first time in nearly a decade included in the statement that inflation risks are “tilted to the upside”, whilst in the press conference ECB President Christine Lagarde did not rule out a rate hike this year. The above events, all taking place within two weeks, have sent shockwaves through the rates market.

You can look in every corner of the fixed income space to see the subsequent impact, from bond markets to swap and credit markets. German Bund yields beyond the 5 year tenor were briefly all in positive territory, the 10 year US Treasury yield has traded above 2% for the first time since 2019 whilst the UK equivalent which moved above 1.5%, the highest since 2018. Long story short, markets have moved a long way very quickly, which opens up the possibility for mean reversion taking some “froth” out of the market – but when momentum is this strong in one direction, you have to be a brave soul to fight the direction of travel.

Even if the current commentary chorus is hawkish, the verses may give some hope for those hoping for a turnaround in the aggressive pricing. For example, forecasts based on future market pricing in the Bank of England’s February monetary policy report show inflation below target in 2025 at 1.6%, signalling that the market may have gone too far. 

Then came Russia’s invasion of Ukraine, creating an opposing force to a rise in rates as investors move into haven assets like government bonds which brings yields lower, and swap rates with it too. The situation is fluid and at the moment it's unclear how long this force will be present and whether it will strengthen.

2022 pathways

We focus on the implied path of interest rates over the next 12 months for multiple reasons. Beyond the obvious need to assess what moves we might see in upcoming meetings, which in turn is a good guide to assess where the above- mentioned momentum may come unstuck, but also what that means for longer- term swap rates. 

Taking a quick look at the current setting, according to the Overnight Index Swap (OIS) market, the UK base rate is expected to be at 2% February 2023, and the market has priced out chances that the BoE’s Monetary Policy Committee (MPC) will raise rates by 0.5% in March given the current global setting. The latest labour market and inflation data continue to support further rate hikes, but increments of 0.25% rises seem the likely way forward. In post-decision comments, Governor Andrew Bailey, and Chief Economist Huw Pill amongst others seemed to prefer a measured approach to raising rates, with Mr Bailey saying that 25bps steps make sense. MPC member Dave Ramsden, who voted for a 50bp hike also hinted that he, going forward, would prefer a gradual rise, after stating that “some further modest tightening” would be appropriate in the coming months. But, as mentioned previously, we have to place an element of caution on anything the MPC says based on its previous record.

The US OIS curve looks very similar, with the forward implied rate at the end of February 2023 also sitting at 2.00% (implies seven 0.25% hikes). Again whether we see a 25bps or 50bps rise in March remains a key debate right now, but like the UK, the market places more weight on a smaller hike. The debate intensified following further acceleration in inflation, with headline and core annual inflation reaching 7.5% and 6% respectively in January. For context, this is the highest inflation reading seen since 1982, when the benchmark Fed Funds rate was in double digits!

Whilst for the UK and US I cannot rule out the scale of increases the market is predicting, and even economists are increasingly coming round to the market’s view (Capital Economics have recently changed their forecast for UK base rate to peak at 2%), I do however cast doubt over the expected moves in interest rates in Europe where the deposit rate, currently -0.5%, was at one point expected to be in positive territory by year end. The market reaction to the ECB’s statement and Christine Lagarde’s comments are probably beyond the comfort zone for many of the Governing Council (GC).– French central bank chief Francois Villeroy de Galhau explicitly noted that the markets may have overreacted. 

The pathway to ending asset purchases is a more pressing issue right now, and with peripheral spreads widening (Tthe 10-yr German Buind-Italian BTP spread in particular) to more uncomfortable levels, and growing anxiety in European credit markets, the ECB knows it is walking a thin tightrope. The ECB’s approach to tightening will likely be gradual, there is the potential for one rate hike this year in my eyes, but all will depend on the deterioration of financial conditions in the coming months. Events in Ukraine have provided another angle for ECB officials to call for caution on tightening, even the more hawkish ones such as Austrian central bank chief Robert Holzmann.

Looking longer term

Given the above commentary and previous notes, I don’t need to explain the direction in which swap rates have gone, the chart below illustrates this clearly. Tensions around Ukraine have allowed rates to pull back slightly however.

The acceleration in volatility is making the market rather tricky, with a lack of liquidity as many price- makers are refusing to give quotes, nevertheless we are still getting hedges over the line, and are as busy as ever talking to customers across the country. The momentum has made hedging more expensive, but the price of certainty for many is still worth paying.

If some froth is to be taken out of the swap market, how will this play out? If central banks do not follow through with the rate increases that the market expects, that does not automatically translate into lower long- term rates, it depends on the context. If economic data starts deteriorating, we may see rates drop off, but the market is incorporating a degree of this already in its pricing, hence why 3- year SONIA swap rates are higher than 5 year rates and beyond (curve inversion). Central banks may have to grind the economy to a halt in order to tame inflation, therefore rates in the longer term will have to be lowered. Some view that this won’t be intentional, and that it will just be the case of a policy mistake, as discussed in October’s Wrap.

In another scenario, central banks holding off on raising rates may actually increase long- term rates, if it is the view of the market that central banks are not doing enough to tame inflation,. In this case, shorter- term rates would fall in line with actual central bank activity, but longer -term rates would have to rise as the can gets kicked down the road, meaning a longer cycle of rate hikes. The curve would re-steepen away from the current flat levels to a more normalised structure. It could also  be an effect of accelerated quantitative tightening (QT), disproportionately impacting longer term rates as the assets held are longer in duration.

The latter is not out of the question. I mentioned in the January Rate Wrap that the Federal Reserve will not be comfortable with the difference between 5 and 10 year rates being around 10 basis points going into a hiking cycle. The Bank of England is already on that journey, and will become even more important if and when base rate reaches 1% where outright sales may commence.

The Ukraine situation complicates matters here, as the full extent of the conflict remains uncertain. Further escalation will be inflationary through the prism of higher commodity prices, but typically central banks will hold firm when the price shocks are viewed as temporary. However with inflation expectations rising and labour markets tightening the risk is that the central banks end up with no choice but to act as the price shock blurs into those expectations. Whilst the UK may be slightly more shielded compared to other areas (like the Eurozone), it is not immune to higher oil and gas prices. All speculation at the moment, but ultimately, and hopefully, the view right now is that this will be temporary in nature.

All the above uncertainty makes hedging discussions even more important. The aim of hedging is not to beat the market, but to minimise risk and bring certainty to cash flows. Please get in touch with your local branch if you want to discuss the options available.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg.