Maximum interest rates may be lower than expected as a slowdown in growth looms

Worsening economic data may force central banks to step back and take a less aggressive stance regarding interest rate hikes, and money markets are betting, after steadily retreating from expectations about where US and UK interest rates might peak.

The equivalent of a half-point rate hike from the Federal Reserve has been priced in over the past three weeks, bringing rates to a peak at 3% next June.

This means a cumulative rise in US interest rates by 210 basis points in this cycle, compared to 255 basis points at the beginning of May, according to the Federal Fund futures contract reflecting expectations of future interest rate movements.

In Britain too, despite expectations of 10% inflation this year, signs of recession are forcing a turn, with 120 basis points of price hikes priced into June 2023, from 165 basis points at the beginning of May. The interest rate may be around 2.4%.

“What the market is doing right now is focusing less on inflation and more on recession risks, which is why we are seeing repricing,” said Flavio Carpenzano, investment director at the Capital Group.

“The markets also believe in the so-called Fed position, that when we see tighter financial conditions and stock markets drop 20%, the Fed will step in.”

He was referring to the prevailing belief that the US central bank will support falling stock markets by easing interest rate tightening.

Global stocks have already rebounded this week as money markets re-price, seven consecutive weeks in a row. But Carpenzano doesn’t think the Fed can soften its stance, given inflation is four times the target rate.

“If your inflation rate is above 0.5% per month, the Fed will have to take a very hawkish stance,” he said.

A correct prediction of the Fed’s pivot is the holy grail of financial markets, given that global stocks have shed trillions of dollars in value since the US and other advanced economies began tightening policy.

The slump in the money market may not come as a surprise, given the slowdown in US housing markets and a string of weak data that has pushed the surprising Citi Economic Index to one of the steepest drops in four weeks in the past 20 years.

Also suggesting room for maneuver, the headline PCE index rose only 0.2% last month after rising 0.9% in March, indicating that inflation has peaked.

Goldman Sachs now sees a 35% chance of a US recession over the next two years, but expects profits to fall anyway — an event that never happened outside of a recession. Some Federal Reserve officials such as Rafael Bostic have urged caution about tightening policy.

Laura Cooper, chief investment analyst at Blackrock, expects a “peaceful tilt” from the Fed by the end of the year, as “policy makers have become more data-dependent after the two 50 basis point interest rate increases set by the market over the next two meetings.”

Thomas Koesterge, chief economist at Pictet Wealth, expects the Fed to pause after two 50 basis point rate hikes, noting that US financial conditions are already at their narrowest in two years.

“You could actually argue that 75% of the work is already done,” Kosterge said, adding that less than 2% US GDP growth – which he expects by the end of the year – is usually an anti-inflationary factor.

In Britain, where a recession is likely, the Bank of England may find it more difficult to undo.

A £15 billion government spending package announced this week means “the Bank of England will need to rise into deflationary territory,” Goldman wrote, forecasting a 25 basis point consecutive rise through February 2023, raising the final interest rate to 2.5%.

Finally, for the European Central Bank, tightening bets are up, with a 160 basis point increase in interest rates expected next year, from 123 basis points in early May. Christine Lagarde, President of the European Central Bank, has indicated that interest rates, currently at -0.5%, will be at 0% or higher by September.

“The ECB will use this as an opportunity to get rid of negative interest rates, and no pivot from the Fed is likely to change that,” Pictet’s Kosterge added.

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