Bank of England catches markets sleeping with rate increase
European Central Bank slashes asset purchases, raises forecasts
But stock markets fall back, taking the shine off sterling and euro
BoE delivers surprise hike
The Bank of England raised interest rates by 15 basis points yesterday in a move that caught investors sleeping on the wheel. While the British economy can certainly handle higher rates given the strength of the labor market and broadening inflationary pressures, the ferocious covid wave that is rampaging through the nation was expected to keep the BoE sidelined until next year.
Instead, inflation worries dominated and policymakers judged that immediate action was more prudent from a risk management perspective. The vote was 8-1 in favor of a hike, which was also striking considering that just two weeks ago some officials were saying it is premature to talk about the timing of rate hikes, and then voted for one.
The pound soared on the surprise decision but surrendered many of its gains in the following hours as risk appetite soured. This highlights sterling’s sensitivity to swings in risk sentiment, a relationship that has been on full display throughout the pandemic thanks to the UK’s twin deficits and its role as a global investment powerhouse.
Looking into next year, this correlation with risk appetite could be the dominant driver for sterling, as market pricing around the Bank of England for three rate increases seems relatively fair given the strength of the economy.
ECB outlines taper path, euro smiles
Meanwhile, the European Central Bank announced a ‘shadow tapering’ and revised its economic forecasts sharply higher, delivering a dose of optimism to the euro. Asset purchases will be reduced sequentially over the next quarters until they reach EUR 20 billion in the final quarter of next year, where they will remain indefinitely.
This was a slightly faster wind-down than expected and coupled with upgraded economic forecasts showing inflation only a couple of ticks below target in 2023, the ECB seems to be charting a course away from excessive stimulus. Of course, speed matters and the ECB will only move at a snail’s pace, wary of not shocking a bond market that has become dependent on QE ‘medicine’.
The euro jumped initially but lost its vigor soon, something evident by euro/yen closing the session virtually unchanged. Yet euro/dollar managed to end higher as the greenback couldn’t muster any strength with US yields falling.
Equities back under pressure, gold climbs
The relief in stock markets didn’t last long. Tech shares in particular came back under fire to erase their post-Fed gains. There wasn’t any clear catalyst for the sudden reversal, although the fact that bond yields also came under pressure suggests the culprit wasn’t central banks stepping on the brakes.
With both monetary and fiscal policy losing its punch next year while valuations are so high, earnings growth will need to do the heavy lifting and the investing landscape could become much shakier as a result. The spectacular performances of the last couple of years are unlikely to be repeated.
Finally, gold has reawakened from its slumber, charging higher as real US yields retreated a shade, putting the shine back into non-interest bearing assets. Heading into 2022, the most crucial question for gold will be whether real yields move higher as inflation fears ultimately calm down and the Fed stops buying inflation-protected bonds. If so, it could be another tough year for the precious metal.