Markets Price the Pivot on Interest Rates

A busy start to 2023 culminated this week with all three of the major central banks making rate decisions.

First up we had the Fed, who as anticipated by the markets hiked by 25bps, taking the fed funds rate to 4.75%. Still, as ever, more focus was given to Powell’s press conference. The end result of his presser was rates lower, dollar lower and risk assets higher – the market interpreted his words as clearly dovish. And though there were some signs of this, he acknowledged that the “disinflation process has started” and was less aggressive in critiquing market pricing than he has been previously (it still feels like the market has gotten ahead of itself).

Alongside his nods to a more dovish Fed, there were clear warnings that we’re not out of the woods yet. He stated that policymakers see a “couple” more hikes – nominally taking rates to 5.25%, some way above the market expected peak of 4.85%. He also addressed market pricing of cuts in the back end of 2023, saying “I just don't see us cutting rates this year”. And yet the market is pricing in a full 50bps of cuts by December this year, from a lower peak than the Fed expects.

This creates an opportunity for hedgers if the market is right and the Fed start cutting, then the two expectations will align and hedges placed now will capture “fair value”. If the markets have overegged the Fed’s dovish intentions and rates don’t fall, then hedges placed now will capture attractive levels for those protecting against rates moving higher.

Next up we had the BoE, who also hiked according to market expectations – moving 0.5% and taking rates to 4%. They were already leaning more dovish than the other two banks and there was no change today. Bailey stated that we had turned a corner on inflation and the MPC removed language saying they would “respond forcefully” if inflation pressures persist. This has left market participants thinking that we are either very close to, or at, the end of the BoE hiking cycle.

Again, the picture in the UK was quite different – CPI figures came in higher than expected at 11.1%. Despite this, rate movements were very muted and the terminal rate hardly budged from 4.5%. Aided by the BoE rhetoric and compounded by large positioning in the market, we actually saw a slight decrease in rates following the print.

Over the last several months, rates have been a one way game but that is set to change – market dynamics are now considerably more nuanced and two-way risk is back on the table. Risk managers ought to consider this carefully when implementing rates hedging strategies going forward as we get used to a two way volatile rates market.

Finally, we had the ECB and again they moved as markets expected by hiking 50bps, taking the target rate to 2.5%. And, just like the two preceding meetings, the markets clung to dovish leanings and pushed rate expectations lower. Lagarde stated that inflation risks were now “more balanced” and that a sustained drop in energy prices could see inflation fall faster than expected. This pushed markets to price in a more dovish end to the year, with the first hints of a cut at the end of 2023.

With core inflation in the bloc still climbing, this price action seems premature at the moment and, as such, presents hedgers with an opportunity to lock in rates or take advantage of cheaper cap premiums.

The markets will be watching data prints closely in the coming months, with both employment and stubbornly high core inflation taking centre stage. The first moves of the year have gone to the doves but it remains to be seen whether this can persist.