Central banks face a credibility issue

An increasing gap between market expectations and official predictions from central banks shows declining trust in monetary policymakers.

The Federal Reserve's official communication at the December 2022 meeting was clear: interest rates will continue to rise in 2023. The so-called "dot plot," which graphically represents the committee's rate projection, forecasts a key interest rate of 5.125% at the end of this year. Not a single voting member expects unchanged or even lower interest rates during the year. If the committee has its way, another 3-4 interest rate hikes of 0.25% each will follow over the next 8 meetings.

However, the expectations of market participants, as seen in the derivatives market, differ significantly from the forecasts of the Federal Reserve. At the end of the year, interest rates are expected to remain unchanged at 4.25%, compared to the current level. While higher interest rates are expected in the middle of the year, rate cuts of the same magnitude are already priced in thereafter. This creates tension. Thus, the market disagrees with the Federal Reserve and does not believe in the official projections.

This is not surprising, as in early 2022, monetary policymakers had guided for rates of 0.75% for the end of 2022, which was priced into the market at the time. As we know now, interest rates rose by a much higher magnitude to 4.25%.

The issue of diverging interest rate expectations between the market and monetary authorities is not new and has been addressed in previous Sound Invest publications. Central banks as prisoners of financial markets were last seen in late summer 2019. Back then, an inverted US yield curve was decisive in the pressure on central banks. Fearing a recession and severe market dislocations, the central bank complied with the market's pressure and lowered key interest rates to provide relief. However, the pandemic followed shortly thereafter, which pushed this remarkable situation somewhat into an insignificant past.

However, the current situation is only partially comparable to 2019, as there were no signs of inflation back then. Nevertheless, there are parallels. The market sees the growing danger of a recession and, despite the inflationary environment, expects monetary authorities to try and rescue the economy once again. Thus, in 2023, either the central banks or the market participants will be wrong. Which expectations come true will probably depend on the further development of inflation.

Moreover, there are divergences in expectations regarding inflation. The Fed sees an inflation rate of 3.1% over the coming year, while the market assumes 2.0%. Even if inflation turns out to be declining and less problematic, it will determine the market's course for the rest of the year. A reason to be cautious: If market participants are right, inflation is under control. However, lower interest rates are already priced into the market. A euphoric reaction to a Fed rate change is therefore unlikely. The situation is different if the Committee's expectation comes true: If interest rates rise more than expected or stay at elevated levels, this could temporarily lead to high volatility or even market disruptions.

In terms of inflation, we continue to focus on wage developments. Renowned economists have highlighted several times that the key to fighting inflation is lower wages. Wages fall as unemployment rises, and rising unemployment is the result of a recession. As a consequence, the effective fight against inflation might only be achieved at the cost of a recession.

In the view of the Investment Committee, the increased risk of recession is not yet sufficiently reflected in financial markets. For example, corporate earnings are expected to grow by 4% in 2023, despite a slowdown in economic growth. We therefore maintain an unchanged tactical underweight in equities, favoring companies with stable cash flows and dividends as well as the healthcare sector. In the fixed income space, we focus on high-quality and government bonds, recommending a higher weighting in USD and GBP markets given superior real yields.