Central banks showed no signs of blinking in the face of mounting inflationary pressure, with interest rate rises of 0.75% from the US Federal Reserve and the Bank of England . However, investors are steeled for bad news and the rate rises were in line with expectations.
The Federal Reserve raised its benchmark interest rate to 3.75%-4%. Fed Chair Jay Powell warned that there was 'some ways to go' in taming inflation, and prices had not yet started to respond to rate rises. However, markets took some encouragement from his hint that the Federal Reserve may be willing to adopt a less aggressive stance at its next meeting.
The Bank of England’s decision was also widely expected. The base rate now rises to 3%. The Monetary Policy Committee said the outlook was 'very challenging' with a lengthy recession likely. However, its view is that interest rates may not have to rise much further to bring inflation within the 2% target, adding that market expectations of a 5.25% peak were too high.
These are undoubtedly large increases - the UK rise is the largest increase since 1989, apart from a brief rise in response to Black Wednesday. Powell has said his preference remains to ‘overtighten’ rather than letting inflation becoming entrenched. However, it appears that financial markets are increasingly prepared for the long haul ahead.
The Fed Futures market is now anticipating an interest rate rise of 0.5% at the December meeting, before stabilising at around 5% in 2023 (as reported in the Bloomberg survey). This looks restrictive, given that the Federal Reserve is forecasting inflation to drop to 3.1% next year. We believe the Fed may have room to slow the pace of rate rises over the coming quarters.
Of course, a lot depends on what happens to inflation. It is still possible that inflation comes in higher than central banks expect. The labour market is relatively buoyant, particularly in the US, which could push up wage inflation. However, US wage inflation, as measured by the last Employment Cost Index, has stabilised, suggesting higher wages are not entrenched.
Energy prices are a major unknown. The latest developments from Organisation of the Petroleum Exporting Countries, (OPEC+, which includes Russia) are not encouraging. The cartel plans to reduce oil output in October, in spite of – or perhaps because of - the West’s hopes that it would act to keep crude oil flowing during this energy shortage. The official reason given for the OPEC+ production cut is that it’s a response to rising interest rates and declining global growth expectations in advanced economies. Either way, it could be bad news for energy prices in the short term.
Nevertheless, we see inflation expectations dropping. The US Treasury Inflation Protected bond market, for example, shows that US inflation expectations have slowed to a projected 3% per annum over the next two years from nearly 5% last March. Opinion poll surveys of consumers also show that expectations of rising prices have come down.
Everyone is watching the Federal Reserve, including the Bank of England. If there were tangible signs that interest rate expectations are stabilising, it would provide an opportunity for equities to recover. Nevertheless, the environment remains uncertain. As such, it makes sense to stay defensive during this energy crisis, owning sectors such as healthcare, consumer staples and utilities, where interest rates do not significantly influence returns. We also like commodity-related stocks (including the oil and gas sector), which have strong cash flows from higher energy prices and discipline on capital spending.
For investors, an interesting divergence is emerging between the rhetoric from the US Federal Reserve and the Bank of England. Fed Chair Jay Powell warned markets not to underestimate the likely path of interest rates, while the UK Monetary Policy Committee said the opposite. This has resulted in sterling weakness in the market today and could continue to have that effect in the short term. Sterling weakness benefits those companies in listed in the UK who derive a considerable proportion of their earnings overseas, like the oil companies, which also look set to continue to benefit from the prevailing environment of high prices.
For the time being, the direction of US interest rate policy will remain the single most important factor in market direction. However, a lot of bad news is now priced into markets and it is plausible that inflation could start to move lower relatively soon.
If this article has raised any questions, please do speak to your usual Evelyn Partners adviser.
All figures stated have been sourced from Refinitiv, as at 3 November 2022, unless otherwise stated.
 Jay Powell warns US rates will peak at higher level than expected, Financial Times, 3 November 2022
 Bank of England raises interest rates by 0.75 percentage points, Financial Times, 3 November 2022
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