Just when it seemed that the central banks could focus solely on inflation, a potential banking crisis has emerged that may derail their plans for a smooth landing and lower inflation. While policymakers appear calm on the surface, like an elegant swan floating across a lake, there is likely a frenzied atmosphere behind the scenes as they work to understand the potential risks.
The post-pandemic world seemingly has one more sting in the tail!
What’s Next for Central Banks?
The bond market is forward-looking and factors in risks, often anticipating changes in policy well ahead of other markets and policymakers. Despite the US Federal Reserve, the European Central Bank (ECB), and the Bank of England tightening monetary policy (albeit at a slower pace than previously), the forward implied rates are now beginning to factor in a loosening of policy later this year. It’s important to note that the Fed resisted the bond market’s sell-off last year, as it believed there was an underlying inflation problem, only for central banks to ultimately follow the bond market’s lead. Now, the bond markets are predicting that the central banks will once again be behind the curve and overtighten.
As we reiterated earlier this year, major central banks are well advanced in moving towards a tight monetary regime through interest rates and QT (quantitative tightening). At the start of the year, financial stability was integral to the monetary regime, but not at the forefront of policymakers’ minds. This is no longer the case, and a shift to a pause in monetary policy is now more likely, even if looser conditions may take longer. The Bank of Canada has already taken this step, and the Fed has hinted that it will be guided more by underlying economic data. In the coming weeks, we will scrutinize incoming data to challenge our base case of a soft landing and a gradual reduction in inflation.
At the beginning of the year, we already reduced risk through asset allocation changes, adding more high-grade bonds and lowering beta across all portfolios. This shift factored in medium-term risks and underlying valuations across bond and equity markets and remains relevant today.
To find more about the latest house views from London & Capital’s Investment Desk, read the full AndPapers Q2 2023 here.