Central banks at the fork in the road

All eyes are on the upcoming US Federal Reserve meeting and whether officials will hit the pause button after 10 consecutive interest rate hikes this week. Positive economic data out of the US last month – such as a resilient labor market with the lowest unemployment figures in five decades – fueled growing expectations among some market observers that the Fed might deliver at least one more rate hike.

We believe the gathering will instead result in a pause as growth and inflation momentum slowly but surely inches lower. Across the Atlantic, we expect the European Central Bank to continue its hiking path with one or two more rate hikes in the coming months.

Is the Fed inching closer to a pause?

One key signal from the Fed’s last statement was that it dropped the phrase “some additional policy may be appropriate”, which many took as a hint that the tightening cycle could be taking a break. Further, Chair Jerome Powell acknowledged last month that the Fed had come a long way in policy tightening and that they face uncertainty about the lagged effects and the extent of credit tightening from the stress in the banking sector, adding, “having come this far, we can afford to look at the data and the evolving outlook to make careful assessments.”

So, let’s take a step back to consider the broader macroeconomic backdrop. The stress in the banking sector that started to wreak havoc in March, aside from generally having a negative effect on growth momentum, is paving the way to tighter credit conditions. Coupled with reduced demand for new loans, this could further weigh on a cooling US economy. And while some parts of the economy have shown resilience, such as the labor market, first signs of weakness have started to appear there too and should gradually continue to do so. This will be worth following, especially as small businesses now describe the very high level of interest rates as their main concern, over higher inflation.

The key measure of core inflation has eased somewhat, and non-housing core services inflation tumbled to 0.1 percent month-on-month – the smallest increase, excluding housing rent, since July 2022. This is crucial as Chair Powell has pointed to core services inflation ex-housing as key in determining if inflation pressures are receding.

The European Area on the path of normalization

In the European Area, the situation, while still fluid, should normalize and evolve and decelerate in the same manner as it is in the US. The additional 100 basis-point rate hikes in the first quarter means that demand for loans fell dramatically again as per the latest first-quarter ECB lending survey released at the end of April. In fact, credit standards are almost back to the tight levels seen during the Eurozone crisis in 2011, according to Morgan Stanley.

The combination of receding inflation, central banks pausing or very near their finishing lines and slower growth momentum (from too hot levels) is welcome and supports our “Goldilocks” thesis for good carry ahead. It also supports our view that of credit spreads that would still perform from current levels in a scenario of weaker growth (or mild contraction), as the latter is well flagged and understood by investors.

We keep a positive stance on the Euro Area investment grade market, anticipating it to continue offering attractive carry returns. A full-scale financial crisis seems unlikely as both the Fed and ECB appear to be nearing the end of their tightening cycles.

The Fed is showing signs of applying the brakes, while the ECB, having increased rates significantly in the first quarter, seems close to its peak given the falling demand for loans and a moderating inflation outlook.

Current market conditions, paired with more cautious central banks, provide investors with good relative value opportunities, particularly for those who might have missed the rally at the start of the year.