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- The sum of financial tightening matters. As the tightening of the credit channel has increased following the recent bank shock, interest rate tightening should be lower than previously anticipated. This does not mean the ECB and other central banks will stop hiking, but we are closer to the peak.
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- We were already gradually closing our underweight duration stance. Recent events might speed up this process, although the repricing in bond markets was very fast.
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- As we are closer to the ECB’s terminal policy rate, curves should continue steepening.
Over the past week, for the first time since central banks started tightening monetary policy, we have seen a clear and abrupt shock to financial markets. Previously we had been discussing that, so far, we had only seen limited effects of the tightening cycle on the real economy. Consumer spending remains healthy, and corporates very profitable.
Now, the main question is whether the US regional bank issues (that have so far been very idiosyncratic and a failure of both regulation and business models) and the credit Suisse troubles will lead to a global contagion of financial institutions. This would cause the developed market central banks to stop the hiking cycle earlier than expected or even reverse course on monetary policy.
So far, we believe this not to be the base case. But the probability that we have reached the highs in policy rates has now significantly increased.
Currently, as it is the case for Credit Suisse, it is about markets chasing the weakest link. This clearly has safe haven effects on Bunds and Treasuries. The fear of financial contagion and a repeat of the GFC and a new sovereign debt crisis in Europe are strongly pushing rates down. This is re-enforced by an anticipation of a U-turn in monetary policy.
Over a short horizon this implies the following risks:
1. Is a peripheral bank next in line? That would mean peripheral spreads idiosyncratically move up compared to the safe-havens. We think it is very unlikely, as CS seems idiosyncratic, and regulators are aware that confidence in the financial system has to remain intact. This has been confirmed in the additional press releases by the ECB and the Fed. In case the risk of contagion increases, they will take clear and strong action. During the ECB meeting on 16 March, it was confirmed that the TPI will indeed be used if this would be required to counter “unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy”. Again, the unconditionality and unlimited purchasing power of this tool has high credibility. This was illustrated when the recent increase in rates was not met with increasing spreads in the European periphery.
2. Would this significantly alter the ECB’s course? We think not, even though that macroprudential supervision could affect monetary policy as in the end financial stability is a secondary mandate. Lagarde clearly stated that the decision to hike 50bps is very sensible from an inflation-fighting perspective, but that financial stability needs to be carefully calibrated with their primary objective. It was one of her best speeches proven by extremely calm markets during the press conference. She highlighted the need for calibration of monetary policy and financial stability making the future path of monetary policy even more data-dependent and that they would not hesitate to use the current toolkit or create new tools that could specifically target financial stability concerns. In addition, the Bank of England has shown that monetary policy can stay the course even when the balance sheet needs to be used to temporarily address a problem. But it should be stressed that a banking shock further increases the transmission of monetary policy through the credit channel. Banks become more cautious in granting credit, both in terms of size and lending standards, thereby substituting to a certain extent the need to hike the monetary policy interest rate.
But over the medium term the required monetary policy stance is not yet fully clear as inflationary pressures are not decreasing as quickly as hoped. Moreover, even though energy prices are strongly decreasing, the stickiness of core inflation is worrisome. Even if monetary policy transmission is happening especially through the credit channel, the pace of transmission might be too slow. Especially taking into account the uncertainty regarding lead-lags of monetary policy has increased, but they are more important than ever.
Even before this recent market event, it was clear that we were getting close to levels where it was appropriate to close the remaining duration underweight in our strategies, as we were getting close to the peak of monetary policy tightening. After the current events, it is likely more effects of the tightening cycle will become visible, requiring the ECB to at least slow down monetary policy tightening, even if the inflation situation is not fully in line with the target. Better safe (i.e. waiting for monetary policy to fully work through) than sorry (i.e. increasing the probability for a policy mistake and potentially having to ease more than you tightened) will become the mantra of central banks once again.
