Decoding the impact of FED and ECB decision

With the major central banks nearing peak rates and markets looking ahead to monetary tightening cycles rolling over, investors were looking to last week’s US Federal Reserve (Fed) and European Central Bank (ECB) meetings for further clues to the path ahead. Our independent investment teams provide a diversity of thinking which is reflected in their wide-ranging views on macro topics such as the inflation and growth outlook and the likely policy path ahead for the major central banks. Here we take a look at their perspectives on the macro outlook and opportunities in fixed income.

Differing views on the path ahead for the Fed

The US Federal Reserve (Fed) left rates unchanged, with the Fed Funds target rate range at 5.00%–5.25%, but kept alive the possibility of raising rates again at upcoming meetings. Franklin Templeton Fixed Income notes that all eyes have been on the US Federal Reserve (Fed) and their policy reaction function as inflation remains “sticky”. The team remains of the view that the Fed will increase the policy rate as needed and hold it there for an extended time as the ultimate impact of tighter monetary and credit conditions develop. They project a shallow recession in the US towards the end of 2023, and below trend growth throughout 2024, and believe that inflation will continue to moderate but will remain above the Fed’s 2.0% target through the end of next year. In its view, the market’s expectations that the US Federal Reserve (Fed) will be quick to respond to any deterioration of economic conditions with rate cuts is disconnected from the Fed’s own guidance. The team’s base case calls for no Fed rate cuts during this year.

Western Asset, meanwhile, felt that the amount of drama surrounding whether the Fed raises rates again at one of the next few meetings seems disproportionate to its importance. The big picture is unlikely to change materially whether the Fed ends its hiking cycle now or after one or two more rate rises. First, any future rate rises are likely to be small relative to the rate hikes already done. Second, the full impact of the rate rises has yet to be felt, as it will likely increase over coming quarters when real interest rates increase further. Finally, the stress caused by elevated funding costs is significant and likely to continue. Western Asset expects the upcoming economic data to provide further evidence of slowing growth and ongoing disinflation and believes this should be enough to forestall the Fed from raising rates as much as indicated in the Fed’s own projections.

Templeton Global Macro highlighted that last week’s central bank actions were in line with their view that the Fed is at or near a peak in rates. It believes a further rate increase this year remains a possibility.

Brandywine Global believes the Fed is likely approaching its terminal rate, but rate cuts may not be imminent. The team has been concerned with macro tail risks due to lagged effects of the most aggressive rate-hiking cycle in modern history.

European Central Bank remains concerned about inflation

The European Central Bank (ECB) raised rates by 25 bps taking the repo rate to 4.00%, adjusted up their inflation forecast and indicated that a further hike in July is likely, in line with market expectations. The Franklin Templeton Fixed Income Team notes that the European Central Bank (ECB) faces its own inflation problem and the bank has made it clear that it is not yet contemplating a pause in its hiking cycle. The team expects the ECB will continue to raise policy rates over the next several meetings. Its base case regards two more rate increases as likely, given the stubbornness of services inflation, with the risks to this call tilted toward additional monetary tightening. Despite a small technical recession in Europe so far this year, it is still their expectation that the economy will return to growth for the rest of the year and into the next.

Templeton Global Macro agrees that the ECB retains a hawkish bent and believes the bank likely has at least one further rate increase in the pipeline. It notes the Governing Council has raised its inflation forecasts and it seems that there could be another increase in July.

Western Asset acknowledges that the ECB remains concerned about higher core inflation (the catalyst for the upward revision in the bank’s inflation forecasts) and that the bank’s concern is premised on higher wages. However, Western Asset believes there is limited wage detail to validate this “new concern”. If anything, it notes that wage growth for existing jobs in the Euro area is declining albeit it from high levels. Additionally, Madame Lagarde noted that it is likely that ECB policy rates will be raised another 25bps at the next meeting in July, broadly in line with market expectations. Western Asset thinks that the significant tightening to date is already gaining traction, particularly in the periphery countries, and additional rate hikes will weaken already soft growth further, pushing inflation lower. The rapid past interest rates hikes which started in June 2022 have yet to fully impact the real economy, a point flagged yet again by Lagarde. But for now inflation concerns are still taking precedent.

Where are our investment teams finding opportunities in fixed income?

Fixed income assets broadly continue to provide strong levels of income, with many sectors now offering some of the highest yields seen in several years. The Franklin Templeton Fixed Income Team believes that shorter- duration, high-quality assets that provide yield and income opportunities remain attractive on a historical basis and can provide downside risk management amid both rising interest rates and widening credit spreads. With the Fed nearing its terminal rate, the team are slightly more constructive on duration than they have been for some time. However, they note that intermediate- and longer-term yields remain too low. With current inflation dynamics, volatility, and Fed policy, they expect there to be upward pressure, but recognize that with these rates at decade-high levels there are buyers here which may limit the near-term potential of rising yields.

Templeton Global Macro believes the greatest areas of value in the sovereign bond markets are to be found in non-USD assets. This view arises from both, consideration of domestic fundamentals in the specific countries, as well as its belief that the US dollar is due for a correction. The team continues to be constructive on risk in select countries, focusing on the core themes of value in select currencies (with overweighted currency exposures focused on countries that have strong trade dynamics, current account surpluses, better fiscal management and stronger growth potential, notably in Asia); and pursuing sovereign bonds where they assess the fundamentals to be favourable. The team has extended duration in select countries where they see opportunity from inflation and interest-rate cycles rolling over, or where they see improving fundamentals in a range of factors from fiscal progress to “nearshoring” and “friendshoring”.

Western Asset notes that across the fixed-income spectrum, investors have choices that offer much more yield than has been generally available over the course of the last 15 years. But investors are reasonably nervous about today’s potential downside economic risks and upside yield risks as the Fed tightening campaign threatens to rumble on. However, it believes a longer-view perspective necessitates taking advantage of the declining inflation trajectory by embracing today’s yields. In this environment, Western Asset favours higher-quality credit that should still capture meaningful upside in a moderate economic slowdown, and that can also prove resilient should more challenging economic headwinds prevail. In terms of duration, they have moved duration positioning more to the front end of the US yield curve believing that the fundamentals strongly suggest a hard landing is both improbable and unnecessary.

Brandywine Global has advocated caution, taking advantage of value but staying up in quality, and relying on developed market government bonds, specifically U.S. Treasuries, to provide value and protection. Although spread volatility will most likely stay elevated in the short term, the team believes yields offer investors compelling income to compensate for the bumpy ride. The team remains confident about bond markets for the remainder of the year because of the opportunities they offer from different economic scenarios, whether it is a hard or soft landing. There are also numerous signs showing that inflation has peaked, including economies slowing at a time when the lag effects of tight financial conditions are impacting underlying economies.