The Strategist

Potential for interest rate cuts vanished

Investors now face higher interest rates in the longer term, both in the US and the euro area. In this environment, one should focus on medium-term growth, inflation and market expectations. We maintain our view on the attractiveness of corporate bonds in both absolute and relative terms.

Date
Author
Thomas Wille
Reading time
10 minutes

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In the first six trading weeks of the current year, investors have already played through or implemented several macroeconomic scenarios. At the turn of the year, capital markets tended to assume only a “slight” recession or, in the opposite case, a “hard landing” of the US economy. This was then quickly replaced by a “soft landing” scenario. After the recent surprisingly robust economic data from the US, especially with regard to the labour market, the question of a “no landing” is now being raised. In this scenario, parts of the economy would cool down too little too fast, while others would accelerate again, leading to renewed price pressure in the system. 

The media, with the urge to create news every day, naturally feel right at home in such a rapidly changing environment. But this also contributes to volatility in the capital markets, as the focus of the business media is often only on the next few days and at best weeks. In such a phase, investors should focus on medium-term expectations of growth and inflation and take into account what the markets – above all the fixed-income market – have been pricing in for the coming quarters.

Higher for longer

Probably the most important change in the last four weeks is that investors are now facing higher interest rates for longer. This is because both with regard to the Federal Reserve and with a view to the European Central Bank (ECB), higher key interest rates are now being expected and also that these will remain high for a longer period of time. 

In the US, one more interest rate step is now expected, but we would currently write this off as background noise. Whether interest rates peak at 5% or 5.25% makes no difference in our view. However, hopes of quick interest rate cuts, or a so-called “pivot”, have been clearly rejected and more than 100 basis points (in four interest rate steps) have been removed from the markets' expectations. We remain of the opinion that the US central bank still has little flexibility for a real pivot.

The picture is similar in the euro area, where financial markets now expect the ECB to keep its key interest rates at a higher level for a longer period. In its current forecasts, the ECB assumes an inflation rate in the eurozone of 6.3% and a core rate of 4.2% by the end of 2023. This hardly leaves any room for interest rate cuts. 

On both sides of the Atlantic we therefore expect higher interest rates for a longer period of time, provided there is no global recession – a scenario that seems to be off the table, at least for the time being. We can therefore conclude that the potential for interest rate cuts has vanished. 

Attractive corporate bonds

Indeed, credit spreads have fallen in recent weeks as extreme scenarios such as a recession or an energy crisis in Europe have been priced out again. Nevertheless, with the rise in interest rates at the short end, the attraction is still there. In the US, the yield on short-term corporate bonds is at the same level as the earnings yield of the S&P 500, which is why we maintain our assessment of the attractiveness of corporate bonds in both absolute and relative terms.

  

LGT Private Banking House View January 2023 All articles LGT Private Banking House View February 2023
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