The past year has been marked by a steep increase in interest rates, as policymakers have taken steps to curb rampant inflation. The US Federal Reserve (Fed) has moved at a much faster clip than its counterparts in Europe to damp price pressures.
The unleashing of pent-up demand after the lifting of Covid restrictions along with fiscal and monetary stimulus to underpin growth during the pandemic had spurred inflation in the US economy. While Europe was hobbled by high energy prices after Russia’s invasion of Ukraine, the US was relatively unscathed on that front.
However, the US economy seems to be softening now, thanks to the series of rate hikes. The tightening of lending standards following the unravelling of Silicon Valley Bank, Signature Bank and First Republic Bank have also tightened financial conditions.
While the US seems to have completed its rate hiking cycle, the European Central Bank (ECB) has some catching up to do. We also expect the central banks in the UK and to some extent Japan to continue to raise rates as the current levels are low.
This divergence is a reverse of what we saw in early 2022, when the US economy’s growth optimism contrasted with the rest of the world. The variance in expectations in different regions throw up relative value opportunities in the fixed income markets. The weaker US Dollar is an obvious sign of these divergent trends.
The Covid years were an eye opener for many Western economies, as the supply chain crunch exposed the fragility of a globalised world. The changed geopolitics marked by Russia’s invasion of Ukraine and simmering tensions between the US and China have also upended many assumptions on the economic front.
While Covid highlighted the pitfalls of depending heavily on China for goods, geopolitical realignments have imposed strains on resources such as oil and gas. Strengthening national defences has once again become a top priority for Western governments after a period of relative serenity following the end of Cold War. The changed scenario means more spending on building capacities in the hydrocarbon sector as well as manufacturing and defence industries.
We have a situation where inflation is much more easily generated amid the low level of trend growth because of the tightness on the supply side. In this environment, interest rates need to be higher than the near zero levels that we are used to in the decade that followed the Global Financial Crisis (GFC).
However, low growth, high interest rates and a surfeit of debt are a heady mix, which could lead to accidents. The ongoing banking turmoil is just an example of that. We are also closely watching the commercial property sector for any signs of stress. We expect this uncertain environment to persist, creating volatility in growth and financial markets.
Core European bonds have been underperforming US Treasuries since November and that trend seems set to continue as lingering concerns over the US banking sector may hasten rate cuts by the Fed, steepening yield curves. The slide in share prices of regional banks as well as the flight of deposits to money market funds and big banks are red flags. Front-end rates in Europe may rise further, with the market pricing in at least 75 basis points of rate increases. Therefore, we expect the US to be relatively far more attractive than Europe in the coming months.
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