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With no respite in inflationary pressures, bond yields are rising significantly as investors position for a substantial ratcheting-up of policy rates by both the ECB and US Federal Reserve later in September.  

Jackson Hole – A hawkish message

At last week’s annual gathering of central bankers and economists in Jackson Hole, Wyoming, Fed Chair Jerome Powell did not mince his words, delivering a hawkish speech specifying the Federal Open Market Committee’s (FOMC) ‘overarching focus of bringing inflation back down to the 2% goal’ and the importance of price stability as the bedrock of the US economy.

Having quashed hopes that the Federal Reserve would step back from its tightening of monetary policy anytime soon, Chair Powell reaffirmed his ‘unconditional’ commitment to tackling high inflation and made it clear that restoring price stability would probably require maintaining a restrictive policy stance for some time.

This would appear to be aimed at countering the market’s expectation of rate cuts relatively early in 2023.

The Fed Chair acknowledged that restoring price stability was likely to ‘require a sustained period of below-trend growth’ with very probably ‘some softening of labour market conditions.’    

Powell noted that the current target range for the federal funds rate of 2.25-2.50% is the level at which the Fed projects the rate to settle in the longer run (i.e. the neutral rate). He then pointed out that in current circumstances, with inflation running far above 2% and the labour market extremely tight, estimates of the longer-run neutral rate were ‘not a place to stop or pause.’

The next FOMC meeting takes place on 20-21 September and Powell did not rule out a third consecutive 75bp increase in the fed funds range. The Fed’s decision at the September meeting will depend on the totality of the incoming economic data with US jobs data due out on 2 September delivering fresh information on conditions in the labour market. Consensus forecasts expect US employers to have added 300 000 new jobs in August, down from 528 000 in July.

Our macro research team forecasts that US core PCE inflation will decline to 3.9% only a year from now, factoring in rate rises that will take the federal funds rate to 4.00%-4.25% in the first quarter of 2023.

Market reaction to Powell’s speech

In the wake of the hawkish messaging from Jackson Hole, US stocks posted four straight days of declines. This resulted in a fall of almost 6% for the S&P 500 and just under 7% for the NASDAQ composite, taking the shine off the rally over the summer (see Exhibit 1).

US stock prices fell in the wake of Fed Chair Powell’s 26 August speech at Jackson Hole

Yields of US government bonds have risen in the wake of Powell’s speech.  The yield on the two-year Treasury note has reached 3.5% this week, its highest since 2007, while the yield on the 10-year US Treasury note has risen to 3.2 %.

ECB meets on 8 September

Europe’s bond markets had a difficult August with eurozone debt hit by heavy selling after July’s rally. Performance suffered as investors positioned themselves for more aggressive central bank monetary policy to counter surging food and fuel prices triggered by Russia’s war in Ukraine.

The sell-off was fuelled further this week after data showed the rate of consumer price growth in the euro area hit a record 9.1% in August. The 10-year German Bund yield rose by just over 0.7% in August to trade at 1.54 %. This is the single largest monthly rise since 1990. Meanwhile, the 2-year Bund yield also registered a significant rise, ending the month at 1.1%.

August saw another strong rise in European gas prices. Futures linked to the wholesale gas contract TTF rose by nearly 40%, taking the rise over the last two months to almost 70%. This week, Russia again halted gas exports to Europe through the Nord Stream 1 pipeline, saying maintenance work was necessary until 3 September.

The US dollar rose for a third consecutive month against the euro. The euro depreciated by 7.4% against the dollar. The minutes of the ECB’s policy meeting in July specifically referred to the euro’s fall as an important change in the external environment implying greater inflationary pressures via higher costs of energy imports invoiced in US dollars.

US dollar strength continued in August

All told, this environment puts pressure on the European Central Bank to accelerate the pace of interest rate rises. In July, the ECB raised its deposit rate, for the first time in a decade, from minus 0.5% to zero. Markets are now pricing in the possibility of a 0.75 percentage point increase at its meeting on 8 September.    

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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