The US Federal Reserve and the Bank of England raised interest rates again this week as central banks walked the line between rising inflation and slowing growth.
On Wednesday, the Federal Open Market Committee lifted its benchmark federal funds rate by half a percentage point – the most aggressive rate increase in a single meeting since 2000 – to a target rate range of between 0.75% and 1% and signalled it was likely it could increase it by the same amount at the next two meetings.
US inflation hit 8.5% on an annual basis in March, its fastest rate of increase in 40 years, while the US economy shrank 1.4% year on year in the first quarter.
On Thursday, the Bank of England increased rates from 0.75% to 1% against a backdrop of soaring food, energy and fuel prices that saw inflation hit a 30-year high of 7% in March and amid warnings the UK economy is expected to contract in the final quarter of this year.
A tale of two yields: US HY vs US IG since 2012 (%)
Source: Bloomberg 5 May 2022
The combination of high inflation and a weakening global economic outlook has fuelled concerns about how far central banks will be able to raise interest rates without overburdening the economy, says Fraser Lundie, head of fixed income – Public Markets, Federated Hermes. “The Federal Reserve now seems determined to tighten until inflation notably slows,” he says.
The Fed’s latest meeting illustrates the central bank’s redoubled focus on inflation and its determination to bring it under control, says Silvia Dall’Angelo, senior economist, Federated Hermes. “With the largest interest rate increase in more than two decades, the Fed will likely continue to hike aggressively in the next few months,” she says.
The yield on the US 10-year treasury edged above 3% this week for the first time since 2018 as traders reacted to tightening monetary policy and ongoing uncertainty. The yield on the US 10-year note was trading at 3.02% at 14:52 GMT on Thursday.
Equity markets briefly rallied following the central bank announcements in the US and UK as investors bet that inflation would be brought under control. The S&P 500 closed up on Wednesday but remained down more than 10% year to date at 15:00 GMT. The UK FTSE 100 closed up 0.21% on Thursday.
“Macroeconomic concerns remain prominent in the market with stagflation at the forefront of investors’ minds,” says Geir Lode, head of global equities, Federated Hermes. “As a result, equity markets have been rewarding defensive sectors that have previously outperformed in stagflationary environments, such as energy, consumer staples, utilities and materials.”
The rising cost of raw materials and energy has exacerbated the deteriorating macro backdrop, leading many investors to move into defensive sectors such as telecoms and the commodity space, says James Rutherford, head of European equities at Federated Hermes. “The fear around an economic slowdown in the second half of the year is also driving more allocation around capital preservation rather than the usual shifting between value and growth,” he says.
The severe lockdowns in China’s major metropolitan areas have led to further supply chain interruptions and this continues to impact company operations all over the world, Lode adds. “It’s a theme frequently mentioned in earnings reports over the past week,” he says.
Nonetheless, Lundie points out that as various stories evolve in US, Asia and Europe, lower commodity prices and lower inflation breakevens could be on the way. “With yields in US investment grade and US high yield now surpassing 4% and 7% respectively, there is good value to be had while we sit and wait,” he says.