The end of rate hikes: Are we there yet?

As the market patiently waits for global central banks to wind down their rate hiking cycles, we wonder, is the journey really this long, or have we gotten lost along the way?

Recent economic data have been favorable for markets. The disinflationary trend that’s been in place for several quarters continues, and core inflation appears to be in retreat across Western economies. Even China is showing signs of deflation, with recent reports of falling producer prices and steady consumer prices compared to a year ago. It would appear to be time to put fears of rising inflation to rest. 

On the other hand, global growth is progressing at an unexciting but non-recessionary pace, near our estimates for potential growth. We believe slow positive growth and disinflation is a good backdrop for market risk takers and should be generally associated with strong risky asset performance. Recent market performance is most likely related to investors’ growing confidence in the slow growth, disinflationary environment and their positioning accordingly.

Central banks hew to their inflation fight

The doubters continue to be led by global central banks, who have continued to raise interest rates, despite what looks to be clear evidence of disinflation. Inflation proved to be higher and more persistent than central banks anticipated coming out of the pandemic lockdowns, and their reaction to this miscalculation seems to be to consciously err on the side of caution now. While the disinflationary trend has been clear, and central banks could plausibly pause to observe the impact of significant rate increases, they’ve continued to hike rates. Central banks also are signaling that rates will likely stay elevated for an extended period. If rates stay high, while inflation continues to decline, the chances of a policy overshoot increase. This could arise through lower-than-desired inflation or a recession. Either of these outcomes would likely damage the current favorable investing environment.

Rate cuts could be a long way off

The question is, how will central banks manage going forward? If evidence of disinflation continues to build, as we expect it will, how will central banks respond? As the risk of lower-than-desired inflation builds, rate cuts would appear to become more appropriate. On the other hand, central bank rhetoric and expectations implied by markets argue that rate cuts may be a long time coming. Higher-than-necessary interest rates will likely increase downside risks in the coming quarters, which is something we, as investors, will need to pay attention to.

An opportunity in bonds

Either way, we conclude that interest rate structures across most developed markets offer value. With interest rates across yield curves close to cyclical highs, disinflation well established, and central banks leaning very hawkishly, we believe investors have a very compelling opportunity in bonds. With the risk of an inflationary spiral off the table, we believe both the base case and risk cases involve solid potential total returns in bonds.