Rates: A Lift-Off Story

Chair Powell maneuvered skillfully the press conference following the Fed meeting on November 3rd. While the Fed delivered the $15 billion per month in tapering as expected, with regards to “lift-off” (i.e., first rate hike from the zero boundary) Powell pushed back by saying that he did not see it before near the end of 2022, a timeline also echoed in Richard Clarida’s speech on Monday.

This was followed by the BoE policy meeting on November 4th. It did not raise the overnight rate, although the monetary policy report acknowledged that inflation will likely hit 5% by next spring and that modest increases in overnight rates were likely warranted.

Many market participants were taken wrong footed, and money market rates dropped abruptly in order to price out rate hikes to less than 3 hikes by June 2022.

Where do we stand now?

Here are 3 observations that can be helpful in framing where we are and what might lie ahead of us.

The divergence in expectations for rate hikes over the next quarters between, on the one hand UK and Canada and, on the other hand, the EU and US is quite important, especially if one considers the fact that economic data is relatively similar and benign among these countries. While such divergences might have been observed in the past – more recently after the global Financial Crisis (GFC) of 2008 when Canada raised rates three times with a Fed on hold – the economic recovery post-GFC was quite different among jurisdictions and easily explained those divergences. Presently, it is difficult to see these divergences persist unless the economic recovery becomes much less synchronous among them.

The highest probability path in our view is therefore the one where these expectations will converge closer: the US – and potentially EU though this is less likely – pricing higher probability of a “lift-off” sooner or UK and Canada expectations for aggressive rate hikes fading away somewhat

The last time overnight rates in the US were close the zero boundary – the infamous ZIRP – was after the GFC and questions surrounding “lift off” pre-occupied the market for nearly 18 months prior to the actual first hike by the Fed in late 2015.

In the months to come as market participants remain closely focused on the questions surrounding inflation, growth and employment to try and frame the timing for rate hikes, we are likely to observe more volatility in the money markets and short-term rates in particular. Such volatility makes for opportunities among others, to tactically establish or adjust any FX hedges in light of changing levels of carry.

It is worthwhile noticing that the MOVE index – a volatility index for fixed income markets similar to the VIX for equity markets – appears to be coming to life again and reached post-pandemic highs last week.