As pandemic conditions recede globally, we are likely to move past peak monetary policy accommodation as developed market (DM) central banks respond, in varying degrees, to persistent above-trend inflation and a more synchronized rebound in global growth next year.
Global Market Strategist
As pandemic conditions recede globally, we are likely to move past peak monetary policy accommodation as developed market (DM) central banks respond, in varying degrees, to persistent above-trend inflation and a more synchronized rebound in global growth next year. All major DM central banks have had to acknowledge the reality of, and expectations for, higher inflation, and how they respond in 2022 will be critical for markets.
We believe central bank policy response will depend on policy flexibility toward higher inflation and broader economic conditions. To be clear though, inflationary pressures are running above target everywhere (with the exception of Japan) and, as highlighted in Exhibit 5, investors firmly believe most central banks should begin hiking rates next year, while the pace at which central banks tighten policy through 2023 and beyond is up for debate. The Federal Reserve (Fed), Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) are all expected to start hiking, while the European Central Bank (ECB) and Bank of Japan (BoJ) have clearly positioned themselves more dovish, in large part due to a historically ultra-dovish policy and pandemic conditions that continue to cause economic activity to ebb and flow.
Exhibit 5: Generally, central banks are expected to quickly lift rates over the next two years, but proceed with caution after 2023
global OIS curves, %
With that said, while we acknowledge central banks will be on the move next year, we still believe markets are too aggressive in their expectations for interest rate hikes and we expect central banks to tilt slightly more dovish and not overreact to high inflation. We think central banks will remain more cautious for a few reasons:
- It’s generally accepted among central bankers that the current bout of inflation is mostly transitory, driven by rising energy prices and supply chain pressures, both of which should begin to moderate next year.
- Monetary policy acts with a significant lag, and policymakers recognize a tightening in rates today could lead to a softening in aggregate demand just when the post pandemic economic surge is fading.
- A slower than anticipated pickup in vaccination rates globally could lead to another wave in cases, challenging the growth outlook.
For investors, as central banks shift to less accommodative policy, we expect this will lead to steeper curves driven by rising long rates as markets recognize that DM central banks will be more gradual in hiking rates, therefore not restricting the rebound in economic activity. More directly, over the course of 2022, we expect the ECB and BoJ to remain on hold; the Fed and RBA to hike once; and the BoC and BoE to deliver 2-3 hikes, much less aggressive than current market pricing (Exhibit 6).
Exhibit 6: Markets anticipate aggressive hiking cycles in 2022 due to persistent elevated inflation
derived from OIS curves
This dynamic suggests investors should look to shorten duration within their core bond portfolios. Moreover, as growth rebounds, credit fundamentals should continue to be supported as default rates will likely remain at multi-year lows. Investors are being compensated at current spread levels for the minimal credit risk in markets; however, further spread compression will be hard to come by. Lastly, emerging market (EM) debt could provide opportunities as many EM central banks have already begun hiking rakes to ward off higher inflation and to defend their currencies, allowing for more attractive valuations relative to DM rates.