Central Banks in Europe Choose Divergent Policy Paths | Lord Abbett
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Economic Insights

Surprising policy moves may exacerbate interest-rate volatility

Read time: 2 minutes

Central bank decisions are surprising markets across Europe, and investors face renewed rate volatility. There are two important pressures on central banks in Europe. First, a recent increase in natural gas prices is shifting expectations towards higher near-term inflation, thus increasing the risk of early and faster rate hikes by central banks.

Second, a market technical factor is intensifying recent rate moves. The sudden revision in near-term inflation resulted in large losses by hedge funds heavily positioned for continued, unchanged short-term rates, according to recent media reports. The unwinding of these positions exacerbated recent rate movements and caused rates to move more quickly than would be the case in the absence of this technical pressure.

The impact of these technical moves meant that when investors looked at market-based measures of future central bank action, they appeared very aggressive, warranting some backlash by central bankers themselves.

European central banks differ in their responses to all these pressures.

  1. Eastern European Central Banks – Central banks in Czechia, Poland, and Hungary all recently tightened monetary policy. They generally view inflation as more persistent than expected. As emerging market countries, they need to combat inflation more forcefully by raising interest rates and appreciating their exchange rates relative to the euro. The appreciating currencies create downward pressure on inflation. The Czech National Bank and National Bank of Poland both surprised markets in the first week of November by aggressively increasing policy rates by 125 basis points (bps) and 75 bps, respectively. Both central banks expect inflation to hit 7% this winter.
  2. The Bank of England – As opposed to both strong growth and strong inflation in Eastern Europe, the United Kingdom faces a quandary of high inflation but potentially slowing growth, a condition that generally causes headaches for central bankers. Market-based expectations of policy rates, in the eyes of the BoE, were too aggressive. Although the BoE still intends to embark on a cycle of tighter monetary policy, by keeping rates steady at its November 4 meeting and providing dovish rate guidance, the central bank effectively reduced market expectations of aggressive hikes.
  3. The European Central Bank – A sharp increase in near-term inflation also put the spotlight on eurozone short-term rates. And technical factors also caused markets to project rate hikes in 2022, far earlier than suggested by the ECB. Although markets struggled to grasp ECB President Christine Lagarde’s comments during the recent policy meeting, consistent messaging by many ECB officials over the past week and some decline in natural gas prices have caused markets to return to expectations of hikes in 2023 for the ECB. In recent days, Lagarde and ECB board members Isabel Schnabel and François Villeroy de Galhau have all denounced the idea of rate hikes in 2022.

What might investors take away from this seeming disconnect? Increasing doubts about the true extent of transitory inflation in Europe and elsewhere create vulnerabilities for markets and increase rate volatility (Figure 1), underscoring the usefulness of rate volatility as an asset class for hedging inflation exposure. Amid this uncertainty, investment strategies that seek to reduce duration, or provide inflation protection with limited duration, may prove appealing.

 

Figure 1. UK Rate Futures Signal Europe’s Interest-Rate Uncertainty
Sterling 90-day future curves for indicated dates

Source: Bloomberg. Interest-rate futures are futures contracts based on interest-bearing financial instruments. This futures contract can be cash-settled, or it can involve the delivery of the underlying security.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

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