The CLO factory pauses for breath
Yesterday was a noisy day for the Bank of England (BoE) and European Central Bank (ECB), usually an undesirable situation for market participants. However, after months of looking through, around and over inflation, it now appears that central banks are taking the necessary action to tackle their primary remit. While this may lead to further short term volatility as the markets factor in the news, we certainly welcome these steps, which boost the credibility of central banks and should help extend the current cycle.
The headlines from yesterday are well known; the BoE hiked by 25bp on a 5-4 vote and just avoided raising rates by 50bp. Meanwhile, the ECB surprised markets by not ruling out a rate rise by the end of the year, should inflation stay elevated, which was a marked shift from the previous meeting. Currently, markets are pricing four further 25bp hikes from the BoE and two 25bp hikes from the ECB for the rest of 2022. For context, this leaves a BoE implied rate of 1.65% by year-end, roughly 60bp higher than the implied rate after the BoE's last meeting in December. Meanwhile, by year-end, the ECB's implied rate is -0.10%, approximately 30bp more than the market was pricing just seven weeks ago.
Given yesterday represented the beginning of a hiking cycle, rates unsurprisingly sold off, and credit spreads widened. However, the action from central bankers to get ahead of inflation is undoubtedly good news, and despite the volatility, investors can take some comfort from the market moves.
Firstly, the markets might be a little too aggressive pricing in so many hikes. Although four members voted for a 50bp move, BoE governor Andrew Bailey suggested he believes a gradual process is required, a sentiment echoed by Federal Open Market Committee members across the pond. Although a 50bp hike is still a possibility, there are plenty of meetings this year to achieve the desired policy goal with 25bp hikes, providing time to gauge how higher interest rates affect the real economy. In addition, we have seen in the last cycle that a variety of conditions must be near perfection for a central bank to continue hiking. Therefore, predicting the rate path, even over the second half of 2022, is extremely challenging given the number of moving parts.
It’s also worth noting the dovish consumer price inflation (CPI) forecasts from the BoE, with inflation expected to be marginally above target at 2.1% in two years and below target in three years’ time at 1.6%. These targets probably hold more weight now, given the BoE has acknowledged the persistent nature of the current inflation, and if correct, probably point to rate hikes not running too aggressively this cycle.
The major takeaway from yesterday for us on the desk was that this action was necessary. Robust action now, with the Fed, BoE and ECB in sync, reduces the chances of a cycle-ending policy error further down the line. Moreover, amid a backdrop of strong fundamentals, acting now is a far better outcome than a reactive policy later on, which would have to be harder, faster, and most likely on a stuttering economy.
We now have to wait until March for the next central bank meetings, and there is plenty of economic data for investors to digest in that period. However, we believe that the actions and rhetoric from the BoE and ECB yesterday, and the Fed last week, will help extend this economic cycle. Getting ahead of the curve is creating a period of mid-cycle softness, which is of course painful, but it's also a chance to lock in higher yields at a time when credit fundamentals are looking very strong.