Active Thinking

At GAM Investments’ latest active thinking forum, David Dowsett shares his views on central bank action amid rising inflation and market volatility.

15 June 2022

• In our view, there are two key events to focus on in relation to the poor performance of markets in recent days. Firstly, on 9 June, the European Central Bank (ECB) clearly signalled that it would begin the hiking process in July, with both a 50 basis point (bps) hike in September and a further hike in October likely. The market expectation is now a rate somewhere above 2%. This first hawkish surprise, which led the market and investment banks to revise their expectations up for future interest rate hikes, also led to a revision higher for Bank of England interest rates.


• The second hawkish surprise was the US inflation print, released on 10 June – in short, a bad number. Year-on-year inflation reached 8.6%, dispelling any expectation that year-on-year rates might tail off over the summer. High food and energy prices persist in the US so it is likely that interest rates will increase gradually over the summer. It is not our base case, but expectations rose of a 75 bps hike at the upcoming FOMC meeting; this would be the first such move since 1994. Regardless, there is now a more general expectation that the Federal Reserve (Fed) will need to move to openly restrictive policy to choke off inflationary expectations. The University of Michigan’s forward looking inflation expectations number, which the Fed pays attention to, has been fairly constant at 3% during this time period, but is now also moving higher. Expectations that rates will reach 4.5-5% are now much more prevalent within the market.


• US gas prices are above USD 5 a gallon on average, adding to negative sentiment. The market reaction has been the most dramatic at the short end of the US Treasury curve with 2-year US interest rates having risen by more than 35 bps since the inflation print on Friday (10 June). US high yield has widened 60 bps over the course of the week and European high yield is 50 bps higher. We have also seen Italian 10-year government bonds move 90 bps higher since the start of June. At the recent press conference, ECB President Lagarde stated that there was a trigger level for ECB support and that the bank has the means to fight fragmentation within European government bond markets. She was not, however, specific on what the trigger point would be, creating further market uncertainty. In our view, Lagarde is right that the ECB possesses these tools and we are not returning to the doom loop scenario that prevailed during the euro crisis, but price action is poor and needs to be watched closely.


• In our view, central banks still seem somewhat obsessed with gradualism and expectations management but the data is moving much more quickly than they are and markets are demanding more decisive action. Eventually, central banks are going to have to deliver that. In our view, the ECB, instead of signalling an interest rate rise, should have begun the process. Arguably the Fed also is behind the curve and while that continues we do not believe there will be any let up for markets. Normally, from a seasonal perspective, the pressure comes off for two or three months during summer. We had seen some tentative evidence that stabilisation in markets is beginning, but recent days have severely put that to the test. The market will be closely watching central bank action and language in the coming days.