The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management
In the face of uncertainty caused by the new Omicron variant of coronavirus, the Bank of England may choose not to raise interest rates this week. But assuming the restrictions required to contain Omicron prove both temporary and limited, then 2022 will see a number of developed world central banks start the process of normalising rates.
Once lift-off begins, the question invariably turns to how high can they go?
According to bond markets, the answer is not very high. The market currently only expects the US Federal Reserve to raise its benchmark rate to 1.6 per cent. This is far more pessimistic than the Fed itself, which sees its long-term policy rate at 2.5 per cent.
The BoE’s interest rate pricing is even more interesting. Its bank rate is expected to rise to 1 per cent in early 2023 but by 2025 the BoE is seen cutting rates back down towards 0.7 per cent. The European Central Bank is barely expected to get its deposit rate back into positive territory.
Why is the bond market so pessimistic about how high policy rates can go?
Investors might point to secular factors as economies mature. Slowing demographics and weak productivity that dents supply growth have certainly put downward pressure on interest rates in recent decades. But these long-term trends have not worsened since the pandemic. If anything, it’s possible that the technological advancements forced by the pandemic may lift productivity.
It may therefore be that investors are leaning on cyclical judgments. I suspect the experience of the past cycle is colouring investors’ perceptions of the coming tightening cycle, given the limited amount of tightening central banks in the developed world achieved prior to the pandemic.
But I would caution against using the past cycle as a template for the coming tightening cycle for three reasons.
First, the interest rate sensitivity of the household sector has probably decreased. This is due to a combination of less debt, and more of that borrowing being on long-term low fixed rates. In the US, household debt as a percentage of gross domestic product has fallen from a high of 99 per cent in 2007 to 79 per cent today. A flurry of remortgaging activity in the past two years has led to households locking in 30-year fixed mortgage rates as low as 2.7 per cent.
In the UK, household debt to GDP has fallen from 97 per cent to 87 per cent. And households are increasingly turning to longer-term, fixed-rate borrowings. Regardless of what the BoE does to rates, these households have their mortgage outgoings protected.
Second, fiscal policy is acting as a stimulant to growth, and will continue to do so in the coming years. This sits in stark contrast to much of the past decade when a big priority was reducing the public debt accumulated after the financial crisis. Post-pandemic governments have changed their tune and I do not see a return to austerity. Having issued record high levels of debt at record-low interest rates, they have lost their fear of debt. Priorities have shifted to building back better and providing the infrastructure needed to facilitate the transition to a low-carbon economy. The US, eurozone and UK have already announced sizeable multi-year investment plans.
Third, geopolitical uncertainty is unlikely to damp growth as it did in the last cycle. Back when the Fed was trying to raise rates in 2018, then US President Donald Trump was locked in an unpredictable trade war with China. Much of the slowing in economic activity that we saw alongside the last Fed tightening cycle was in investment, which I’d argue was better attributed to trade uncertainty than higher interest rates.
Things weren’t much better in Europe. Brexit was a dark cloud over both the UK and EU. This sat alongside tensions between northern and southern Europe that lingered from the sovereign debt crisis. While 2022 will not be free of geopolitical events, I don’t see any of them being as disruptive as those that occurred pre-pandemic.
Put simply, in the past cycle the combination of high household indebtedness, fiscal austerity and geopolitical uncertainty acted as a brake on demand. The central banks, therefore, didn’t have to apply much additional pressure for demand to meaningfully slow.
But many of these former braking forces are now acting as an accelerant. The central banks might now have to brake harder.
Investors should be very conscious of what this might mean for positions in government bonds. If I’m right, then over the coming years government bonds will prove to be anything but the “riskless assets” in our portfolios that they are traditionally seen to be.