Erste Asset Management Investment Blog

Interest rate policy quo vadis? 3 monetary policy scenarios

Interest rate policy quo vadis? 3 monetary policy scenarios
(c) Unsplash

Over the past few days, I have received inquiries and comments on inflation and central bank policies that point to heightened uncertainty. The range is wide. On the one hand, it is emphasized that the phase of high inflation rates is only temporary because it is energy price- and pandemic-related. Therefore, key rate hikes would be a policy mistake. On the other hand, however, there is also the opinion that key rates are clearly too low because we are experiencing a regime change toward persistently higher inflation rates. 

Choosing the right side will have a significant impact on the development of a securities portfolio. Unfortunately, it will be some time before macroeconomic indicators clear the fog. Moreover, there may be a third possibility that indicates a way out of the phase of heightened uncertainty. Investors are in good company. Central banks have also been surprised and unsettled by high inflation rates. This has brought about a change in strategy in the basic stance of monetary policy.

Notice: Past performance is not a sufficient indicator of the future performance.

Strategy 1: dovish policy

Before the period of high inflation rates, central banks wanted to pursue a slow normalization strategy. In the first year of the pandemic, expectations were for cautious rate hikes only starting in 2024. Over the past decade, inflation in the advanced economies has been too low, i.e., below the respective central bank target. A prolonged period of economic expansion and a positive output gap (overheating) should help to improve the supply side (fallen labor market participation rates, fallen employment rates, fallen productivity growth), which was adversely affected by the pandemic.

Strategy 2: hawkish signals

Persistently high inflation rates and increasing secondary round effects (higher transport and energy costs exert general cost pressures) increase the risk of (significantly) rising inflation expectations. In addition, although the labor market is not (yet) strong (employment rates slightly above pre-pandemic levels in an increasing number of countries), it has become tight surprisingly quickly. Unemployment rates are reaching low levels in more and more countries, more precisely the NAIRU (Non Accelerating Inflation Rate of Unemployment) range. This is the level below which pressure for rising inflation rates increases. Central banks cannot particularly influence current inflation rates. The higher prices for energy, transport and food have little to do with the low level of interest rates. Central banks can, however, try to prevent a pass-through from current high inflation rates to inflation expectations by sending sharp (hawkish) signals. The new policy is an earlier and faster exit from the expansionary monetary policy stance. By the end of the year, key interest rate hikes totaling 1.6 percentage points to 1.7% are priced in for the US, and 0.46 percentage points to -0.12% for the eurozone. The neutral interest rate level is to be reached earlier. This is the interest rate assumed to have neither a supporting nor a dampening effect on economic activity. For the USA., the market is pricing in a neutral interest rate of just under 2%, for the euro zone around 1% (measured by the priced-in interest rate with a five-year maturity in five years).

Strategy 3: restrictive monetary policy

If inflation expectations drift upward despite an earlier and faster exit, central banks would be forced to prevent a positive output gap via a cooling of demand (economic growth) to meet the inflation target. The policy rate would be raised above the neutral level, meaning monetary policy would become restrictive. Classically, recession risk would rise because central banks have often overdone it with interest rate hikes in the past.

Interest rate hikes expected

In the developed economies, market expectations for significant key rate hikes have risen rapidly. These have halted the carry investment regime. Stable short-term interest rates no longer lead to indiscriminate demand for yield premiums for credit risk (TINA for There Is No Alternative to Risk Assets). For investment grade bonds, the focus is on interest rate sensitivity (duration risk) and the break-even spread (the negative effect of interest rate increases is just as large as the positive effect of the yield premium). For risky (below investment grade) bonds, credit risk is considered more closely: Higher refinancing and repayment risk due to higher interest rates. In addition, higher yields put pressure on asset class valuations (lower prices). In other words, rising government bond yields mean that government bonds are more attractive, putting pressure on riskier forms of investment.

While US government bond yields have already risen significantly, the first rate hike in 7 years is (still) a long time coming
Notice: Past performance is not a sufficient indicator of the future performance.

Supportive Financial Conditions

The immediate key question is whether the overall financial environment (financial conditions) merely becomes less accommodative or even restrictive. As long as a neutral interest rate level is sufficient for stable inflation expectations, the change in central bank policy generates asset price fluctuations, but financial conditions do not become restrictive (baseline scenario). The fear that a restrictive interest rate level is needed to contain inflation expectations (including an increasing probability of recession) is part of a risk scenario.

Rising neutral interest rate level

In the medium term, however, it is at least as important whether the neutral interest rate level will rise. There has been a heated debate about this for years. The arguments in favor of a rising trend in interest rates are that demographic developments (aging), the high investment requirements to combat climate change and generally persistently high budget deficits could lead to a declining savings surplus. If this were indeed the case, central banks would have to raise more than thought without the interest rate level having a restrictive effect on the economy. But pronounced rate hikes to a new, higher neutral level would be restrictive for financial conditions. This is because downward pressure on the valuation of numerous securities classes would increase. Moreover, this pressure would be structural in nature and not merely cyclical as in the case of a recession.

Conclusion

What remains is that as long as inflation expectations remain stable, i.e. do not drift significantly and persistently upward, central banks will raise key interest rates to a neutral level sooner and faster. In this environment, the financial environment will remain positive, even if asset price fluctuations increase. In the two risk scenarios (recession risk or higher neutral interest rate), the trade-off between fighting inflation and financial stability increases.

Legal note:

Prognoses are no reliable indicator for future performance.

RESPOND TO THE ARTICLE

Legal disclaimer

This document is an advertisement. Unless indicated otherwise, source: Erste Asset Management GmbH. The language of communication of the sales offices is German and the languages of communication of the Management Company also include English.

The prospectus for UCITS funds (including any amendments) is prepared and published in accordance with the provisions of the InvFG 2011 as amended. Information for Investors pursuant to § 21 AIFMG is prepared for the alternative investment funds (AIF) administered by Erste Asset Management GmbH pursuant to the provisions of the AIFMG in conjunction with the InvFG 2011.

The currently valid versions of the prospectus, the Information for Investors pursuant to § 21 AIFMG, and the key information document can be found on the website www.erste-am.com under “Mandatory publications” and can be obtained free of charge by interested investors at the offices of the Management Company and at the offices of the depositary bank. The exact date of the most recent publication of the prospectus, the languages in which the key information document is available, and any other locations where the documents can be obtained are indicated on the website www.erste-am.com. A summary of the investor rights is available in German and English on the website www.erste-am.com/investor-rights and can also be obtained from the Management Company.

The Management Company can decide to suspend the provisions it has taken for the sale of unit certificates in other countries in accordance with the regulatory requirements.

Note: You are about to purchase a product that may be difficult to understand. We recommend that you read the indicated fund documents before making an investment decision. In addition to the locations listed above, you can obtain these documents free of charge at the offices of the referring Sparkassen bank and the offices of Erste Bank der oesterreichischen Sparkassen AG. You can also access these documents electronically at www.erste-am.com.

N.B.: The performance scenarios listed in the key information document are based on a calculation method that is specified in an EU regulation. The future market development cannot be accurately predicted. The depicted performance scenarios merely present potential earnings, but are based on the earnings in the recent past. The actual earnings may be lower than indicated. Our analyses and conclusions are general in nature and do not take into account the individual characteristics of our investors in terms of earnings, taxation, experience and knowledge, investment objective, financial position, capacity for loss, and risk tolerance.

Please note: Past performance is not a reliable indicator of the future performance of a fund. Investments in securities entail risks in addition to the opportunities presented here. The value of units and their earnings can rise and fall. Changes in exchange rates can also have a positive or negative effect on the value of an investment. For this reason, you may receive less than your originally invested amount when you redeem your units. Persons who are interested in purchasing units in investment funds are advised to read the current fund prospectus(es) and the Information for Investors pursuant to § 21 AIFMG, especially the risk notices they contain, before making an investment decision. If the fund currency is different than the investor’s home currency, changes in the relevant exchange rate can positively or negatively influence the value of the investment and the amount of the costs associated with the fund in the home currency.

We are not permitted to directly or indirectly offer, sell, transfer, or deliver this financial product to natural or legal persons whose place of residence or domicile is located in a country where this is legally prohibited. In this case, we may not provide any product information, either.

Please consult the corresponding information in the fund prospectus and the Information for Investors pursuant to § 21 AIFMG for restrictions on the sale of the fund to American or Russian citizens.

It is expressly noted that this communication does not provide any investment recommendations, but only expresses our current market assessment. Thus, this communication is not a substitute for investment advice, does not take into account the legal regulations aimed at promoting the independence of financial analyses, and is not subject to a prohibition on trading following the distribution of financial analyses.

This document does not represent a sales activity of the Management Company and therefore may not be construed as an offer for the purchase or sale of financial or investment instruments.

Erste Asset Management GmbH is affiliated with the referring Sparkassen banks and Erste Bank.

Please also read the “Information about us and our securities services” published by your bank.

Subject to misprints and errors.

Share post:
Exit mobile version