Capital Economics: Central banks insist on raising interest rates amid the crisis

Ha Eleftherias Cortalis

Capital Economics said that with major central banks pushing to raise interest rates despite persistent concerns about financial stability, recent markets resilience will prove short-lived even if bond yields continue to fall.

This week, the Bank of England (BoE) continued its tightening cycle, raising interest rates by 25 basis points, echoing a similar tone to recent announcements by other central banks such as the Federal Reserve, European Central Bank and Swiss National Bank (SNB). ) and the Norwegian Central Bank. As policymakers prepare to respond if the turmoil in the banking sector takes another turn, interest rates will continue to rise given how above-target inflation rates are in most economies – the latest inflation figures for February were particularly strong in the US and UK.

Two things stand out regarding investor reaction to these recent meetings of major central banks, Capital Economics notes.

First, while government bond yields in most economies have fallen overall, yields on short-term government bonds have fallen much more than long-term bond yields. For example, the yield on the two-year US bond fell by 23 basis points, but the yield on the 10-year note fell by 10 basis points. After the Fed meeting. Similarly, the yield on two-year British bonds fell by 20 basis points. and for 10-year-olds by 10 metres. After the Bank of England announcements.

In other words, yield curves are beginning to slope downward from deep reversal levels, indicating that investors believe that the end of interest rate hike cycles is imminent and that the probability of interest rate cuts has increased soon. This makes sense, notes Capital Economics, because of the deteriorating prospects for economic growth and the fact that most central banks now see themselves moving interest rates above the “neutral rate” over the medium term.

Second, stock markets have been doing relatively well amid growing concerns about the growth outlook, which is a surprise. The S&P 500 in the US and the FTSE 100 in the UK are almost unchanged from what they were before the central bank meetings. One reason for the resilience of markets is the boost given to equities by declining real yields (although this rosy view ignores the history of yield curve reinflating in the US, which has often been accompanied by sharp declines in equity markets).

From a Capital Economics point of view, the move in bond yields makes sense given potential (additional) disruptions to the banking industries. Capital Economics’ forecasts are broadly in line with investors’ expectations for interest rates for the Bank of England and the Federal Reserve for the rest of the year. Therefore, US and British government bond yields are expected to decline gradually with interest rate cuts approaching later this year.

Conversely, Capital Economics does not believe that equities have been fully priced into the deterioration in growth expectations in developed markets that is reflected by the sharp decline in short-term yields.

The latest announcements from the central bank’s meetings reinforce her view that the bond and stock markets are unlikely to move in opposite directions for much longer.

Capital Economics still believes that the S&P 500 will decline, likely below 3600, the low it hit last October, in the coming quarters amid disappointing economic growth and that other developed market equity indices will also be pressured with the effects. Ongoing monetary tightening and ongoing turmoil in the US regional banking system continue to emerge.