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Hut, Hut, Hike!

June 20, 2022
7 min read
Hut, Hut, Hike!

This week was a huge one for interest rate decisions, with hikes coming from the Fed, the Bank of England, and – to markets’ big surprise – the Swiss National Bank. The European Central Bank, meanwhile, convened an emergency meeting to counter surging borrowing costs in the region’s weaker economies. To add to the global drama, traders are trying to “break” the Bank of Japan by heavily betting that the central bank will be forced to abandon its pledge to cap yields.

Macro

Data out on Tuesday showed real wages in the UK fell the most in at least 21 years in April. Inflation-adjusted earnings, excluding bonuses, were 3.4% lower in April than a year earlier – the biggest drop since records began in 2001. There’s no sugar-coating it: the data is pretty bad news for the UK economy and is only set to increase recession fears. That’s because falling real wages will dent consumer spending – the biggest driver of the British economy. It also comes at a time when Brits are already facing a cost-of-living crisis stemming from the soaring prices of energy, food, rent, and more.

Real wages in the UK fell the most in over two decades. Source: Bloomberg

Wednesday was a big day for major central banks. Let’s start off with the US Federal Reserve, which increased interest rates by 75 basis points – the biggest hike since 1994. It also signaled that another hike of that size was possible at its next meeting in July, all part of its plan to control soaring inflation. The Fed’s been slammed by critics for not anticipating the fastest price gains in four decades and then for being too slow to respond. Just last month, Fed chair Powell had dismissed the idea of “jumbo” rate hikes of 75 basis points. But his hands were most likely tied after the release of two reports a week ago that showed an unexpectedly large jump in consumer prices in May and a sharp rise in inflation expectations.

Big increases in inflation expectations most likely helped galvanize a jumbo rate hike of 75 basis points at the Fed. Source: Bloomberg

In new projections, the Fed forecast interest rates would rise even further this year to 3.4% by December. That was a big upgrade from the 1.9% they projected in March, and suggests the Fed may implement at least one more 0.75 percentage point increase this year and a couple of half-point adjustments before moderating to a more typical level of quarter-point increases. It forecast economic growth to slow to 1.7% this year compared with the 2.8% expansion projected in March. Lastly, one of the most notable changes in the Fed’s policy statement was the omission of the phrase “the committee expects inflation to return to its 2% objective.” That suggests the bank sees price pressures persisting over the medium term.

The Fed's latest "dot plot" shows interest rates are going to rise even further this year, to 3.4% by December and 3.8% by the end of 2023. Source: Federal Reserve

The Fed is not alone in its efforts to try to tackle inflation, which has become a global problem. In a dramatic turnaround from what it had been signaling at the start of the year, the European Central Bank will start raising interest rates for the first time in 11 years next month. But those expectations of higher rates have created a new problem: they’ve sent borrowing costs surging in the eurozone’s weaker economies.

In fact, bond yields of countries like Italy and Spain hit their highest in 8 years this week, reviving fears about a potential repeat of the damaging debt crises in 2012 and 2014 that nearly tore the eurozone apart. So on Wednesday, the ECB convened an emergency meeting to speed up work on a new policy tool to narrow the cost of borrowing gap between more stable countries like Germany and more vulnerable member states.

The spread between Italian and German 10-year government bond yields has surged this year. Source: Bloomberg

Also on Wednesday, Japanese 10-year government bond futures slumped by the most since 2013. Traders are betting that the Bank of Japan will be forced to abandon its pledge to cap yields at 0.25% – an ultra-loose monetary policy that’s in sharp contrast to other major central banks, and one that many traders view as unsustainable. The BoJ is under pressure to tame inflation at home, which is only set to get worse as the yen tumbles to a 24-year low against the dollar. A weaker yen, after all, increases the cost of importing essential commodities, which are all denominated in dollars.

Japanese government bond futures saw their biggest daily decline since 2013. Source: Bloomberg

A day later, the Bank of England hiked rates for the fifth time in a row, increasing its benchmark rate by 25 basis points on Thursday to 1.25%. A minority of officials pushed for a hike double that size, and they might soon get that: BoE governor Bailey hinted that the central bank may join the growing global trend of larger hikes if inflation continues to soar. The BoE also raised its forecast for the peak of inflation this year to “slightly above” 11%, reflecting the planned increase in the energy price cap in October, and said it now expects the economy to contract by 0.3% in the current quarter. Also on Thursday, the Swiss National Bank unexpectedly raised interest rates for the first time in 15 years.

Commodities

Europe’s energy crisis is likely to get worse after European natural gas prices surged on Thursday as Russia reduced crucial gas flows to the continent. Benchmark futures prices increased as much as 24% – adding to the 46% rise this week – after state-backed Gazprom limited supplies to Germany and Italy through a key pipeline. While the EU and the UK have moved to reduce their reliance on Russian gas since the conflict, they're still reliant on pipeline exports from Gazprom for about a fifth of all supplies. According to Wood Mackenzie, Europe risks completely running out of natural gas stockpiles in the middle of peak winter demand should Russia’s supplies via the critical pipeline stop entirely.

Natural gas prices surged this week as Russia's supply reductions added to a recent outage by a US LNG facility. Source: Bloomberg

Crypto

Barely a month after the dramatic collapse of Terra, whose Anchor protocol enticed investors with annual yields of almost 20%, crypto lender Celsius halted withdrawals on its platform offering similarly huge returns. The move by Celsius – one of the biggest crypto lenders and a key player in the world of decentralized finance (DeFi) – came on Sunday evening after weeks of speculation over its ability to honor the outsized returns it offers on certain products, including yields as high as 17%. 

The news was the latest blow to the crypto market and sent prices sharply lower on Monday – especially prices of coins and tokens linked to lending/borrowing protocols. Terra’s implosion is still on investors’ minds, after all, and that episode highlighted that – like the traditional banking system during the global financial crisis – various cryptos can be so interlinked that a problem in one protocol can set off a great unraveling in the wider DeFi sector.

The MVIS CryptoCompare Digital Assets 100 Index, which is a market cap-weighted index of the 100 biggest tokens, dropped 16% on Monday. Source: Bloomberg

Next week

The flash PMI – a survey of business sentiment that serves as a key forward-looking economic indicator – will be released towards the end of the week for the US, UK, Eurozone, Japan and Australia. The surveys will offer a first look into worldwide economic conditions in June. Over in the UK, May’s inflation report is out on Wednesday with retail sales (also for May) due on Friday. The reports will offer further clues on the escalating cost-of-living crisis in the UK and how that’s impacting consumer spending.

General Disclaimer

This content is for informational purposes only and does not constitute financial advice or a recommendation to buy or sell. Investments carry risks, including the potential loss of capital. Past performance is not indicative of future results. Before making investment decisions, consider your financial objectives or consult a qualified financial advisor.

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