At the beginning of October the feeling that the inflation monster had been defeated in the United States and, especially in the euro zone, became the driving force of the markets. The ECB saw inflation data, for September, fall below its 2% target for the first time since June 2021, and the pieces seemed to fall into place for the central bank’s rate reduction process. However, during the month some worrying signs have begun to appear, especially in the United States, which have led markets to reconsider the possibility that inflation could pick up again. The bonds are suffering in their prices and, In a few days, a rate cut has been erased from the Fed’s scenario, and also from the ECB’s, for the next 12 months.
The reaction of the markets in recent weeks has been evident. Despite the fact that the Federal Reserve aggressively lowered interest rates on September 18 (50 basis points), and the European Central Bank decided to lower them by 25 basis points on October 17, in a meeting in which the In the midst of this process, fixed income has been suffering widespread sales, which fit more with a scenario of less aggressive rate cuts.
What do the markets fear? Investors are making it clear that the path to lower rates is not going to be easy. The US bond maturing in 10 years, for example, has gone from 3.6%, the lowest of the year, to 4.2% in a single month, an upward trend in the yield to maturity of the security that discounts fewer declines. of rates by the Fed and some concern about inflation. Its European counterpart, the 10-year German bond, is moving in the same direction: on October 1 it marked 2.03% yield to maturity, the level at which the year started, and in a few weeks it has climbed to 2.31%.
These movements in fixed income have occurred at a time when central bankers in the euro zone are aligned towards continuing the rate cut that began in June. However, this is not so clear in the United States, where the last decision to lower rates was not unanimous, and some dissenting voices have emerged within the Fed. Some members are not clear that inflation is tamed enough to be able to lower rates aggressively, and there are some indicators that indicate that the prudence of the money lords in the United States is justified. Jeffrey Schmid, president of the Kansas City Fed, is one of the voices now advocating a slower decline in interest rates, and this week he acknowledged being inclined toward a cycle of “modest” adjustments and avoiding rate movements. “excessively strong.”
All of this has weighed on expectations of rate cuts that markets are pricing in for the next 12 months. A week ago, six rate cuts of 25 basis points were expected by the ECB in the next seven monetary policy meetings that the body is going to hold, and now five are expected. The same has happened for the Fed: seven days ago six rate cuts of the same caliber were expected in the next eight meetings, and now expectations have been moderated and five cuts are discounted.
Fund managers are also showing more concern about a new spike in inflation, a fear that has led them, in early October, to sell bonds at the fastest pace in history. While it is true that most of those surveyed by Bank of America in October still think that inflation will continue to moderate in the next 12 months, expectations that this will happen are the lowest they have been seen since April 2022 , and The possibility of a new rise in inflation has once again been placed as the second greatest danger that they perceive at this moment, only behind the geopolitical tensions.
The worrying signs of inflation
In the last meeting of the ECB, on October 17, Lagarde recalled that it is possible that there will be temporary inflationary spikes in the coming months, but that it will be a temporary situation and in 2025 the inflation objective maintained by the organization will be reached again. sustainable way. However, the president also warned of the need to be flexible, because the situation can change quickly and a victory against the inflationary monster should not yet be celebrated. In the United States, with stronger growth and inflation than in the euro zone, and a lower unemployment rate, the inflationary threat is even more evident.
The main indicator that warns that inflation is not completely overdue is the data on long-term inflation expectations (the swaps inflation 5y5y), one of the future price evolution metrics that central banks most monitor to decide the course of their monetary policy, since they reflect the inflation that the markets believe there will be in the five years that will begin in five years. Its evolution is now a cause for concern, as Arif Husain, head of fixed income and fixed income CIO at T. Rowe Price, warns that “a rebound in long-term inflation expectations is also contributing to the increase in the US Treasury term premium”.
The increase in inflation expectations has been rapid in recent weeks. Just a month ago, the indicator in the United States hit multi-year lows, at 2.33%. Since that moment it has not stopped rising, up to the current 2.55%, levels very far from the 2% objective maintained by the American central bank. The trend has been the same for the European inflation swap: it has gone from the 2.03% it maintained a month ago to 2.2%, an uncomfortable level for the European central bank, which may perceive this rebound as a threat to the fulfillment of its objective in the medium term.
This rise in inflation expectations is reminiscent of the one that occurred at the beginning of the year. At that time, central banks were expected to begin lowering rates from the first month of 2024, but the increase in inflation expectations, thanks to a stronger than expected economic context, especially in the United States, delayed the start of the rate cut until the second half of the year. This is a reminder that rising inflation expectations must be taken seriously and Steven Blitz, economist at TS Lombard, warns: “There is a growing feeling that the overall conviction that inflation is going to return to 2% is based more in faith than in deeds,” he explains.
In this sense, the Bank of Hungary has joined the alert this week, and points to the threat of energy prices as responsible. In its opinion, “there are still high risks of inflation due to energy prices,” the organization highlights.
The impact of the elections in the US due to the promise of stimuli
The main argument that is increasing fear of inflation has to do with the impact that the US elections will have on the price index, especially if Donald Trump wins the presidential elections in the country. The promise of fiscal stimuli, combined with the imposition of tariffs that the Republican candidate has promised if he comes to power, are two elements that will put upward pressure on prices, according to many analysts. For those who consider inflation to be an exclusively monetary phenomenon, the promise of new billion-dollar injections of fiscal stimuli will make prices rise again.
The proposed 60% tariffs that Trump has launched on imports of Chinese products in these elections, and 10% on all imports from the rest of the world, will lead to the GDP deflator (an alternative way of measuring inflation, preferred for the Federal Reserve) up to 3.7% in 2025, according to calculations by Bloomberg Economicsa rebound that will take the organization away from its objective and will force it to radically stop the rate increase in the coming months. For Goldman Sachs, these policies will add one more percentage point to inflation in the United States.
Nannette Hechler-Fayd’herbe, CIO of Lombard Odier, points in the same direction, highlighting elEconomista.es in an interview at the beginning of the month that “if Trump wins, it is very possible that the Fed will not be able to lower rates to 3.5%, as it anticipates,” he indicates. Robert Dishner, fund manager at Neuberger Berman, agrees, stating to Bloomberg that “with less than two weeks until the US elections, concerns about the fiscal position and greater inflationary pressure are growing.”
The possibility of forming a government with a majority in the US Congress is the great threat, especially if it is a Republican victory, since it would allow the winner to implement his measures without being stopped by the opposition. “A Trump victory could lead to a more significant change. His commitment to tax cuts and deregulation could translate into slightly higher growth than Harris, but the promise of tariffs and anti-immigration policies could also lead to a rise in inflation” , explains Caspar Rock, investment director at Cazenove Capital.
#Fed #ECB #tread #carefully #rise #inflation #temporary #expected
