Fed's Rate Hike Restart Is Likely the Final Monetary Policy Move in 2023

After pausing in June, the Federal Reserve (Fed) resumed its inflation fight Wednesday with another quarter-point interest rate hike. The Fed’s short-term interest rate target is now 5.25% to 5.5%, a 22-year high. Meanwhile, the rates of annual headline and core inflation have continued to moderate, slowing to 3% and 4.8%, respectively, in June.

As we’ve noted previously, it takes many months for the full effects of Fed tightening to weave through the economy. After 11 rate increases that lifted the key lending rate 5.25 percentage points in 16 months, we think the Fed is finished. In addition to inflation’s slide, we’re seeing slowdowns in manufacturing, existing home sales and corporate profits, which suggest the Fed’s campaign is working.

Elsewhere, though, central banks have more work to do. Inflation remains notably higher and more persistent in the U.K. and eurozone, despite sharp declines in economic growth.

Course Change Appears Imminent for Global Monetary Policy

With economic cycles churning at different speeds, leading central banks are rethinking their strategies. From aggressive monetary tightening in Europe to a winding down in the U.S. to rate cuts in China, central bank synchronization is waning.

Amid this shift, our views on global fixed-income opportunities are also changing. Given U.S. inflation trends and the Fed’s action to date, we continue to favor U.S. bonds. But as economies cycle and the impacts of global policy divergence unfold, we expect non-U.S. bonds to gain appeal.

Differing Dynamics Drive Diverging Monetary Policy Paths

The first signs that global policy views were deviating emerged in June. Following the Fed’s decision to hold rates steady amid moderating inflation rates, the European Central Bank (ECB) lifted rates by another 0.25 percentage point. The hike marked the ECB’s eighth consecutive rate increase, even though the region entered a recession in the first quarter.

For its 13^th consecutive rate increase, the Bank of England (BoE) tightened by a surprising 0.5 percentage point in June. Policymakers took the aggressive stance even as the nation’s economic output was nearly flat in the first quarter. Meanwhile, the U.S. economy grew by 2% in the first quarter.

While annual inflation rates have also eased in Europe and the U.K., to 5.5% and 7.9%, respectively, they remain well above central bank targets. Prices are also rising faster than in the U.S.

Elsewhere, the People’s Bank of China moved in the opposite direction, cutting two key lending rates to pump up the nation’s sagging economy. In Japan, where inflation is above target, policymakers maintained their ultra-loose monetary policy, keeping the short-term lending rate at -0.1%, where it’s been since 2016.

Fed’s Resolve Gives U.S. Bonds an Edge

The Fed has outmaneuvered its European peers in the battle to tame inflation. Inflation has proven to be a more challenging foe for the ECB and BoE, which until recently, haven’t been as aggressive as the Fed.

After boldly lifting rates by 5.25 percentage points since March 2022, the U.S. inflation rate finally slowed enough for policymakers to consider a permanent pause. While the Fed has left the door open for additional rate hikes, we doubt more tightening will be necessary.

In addition to inflation, the U.S. labor market, which has proven surprisingly resilient, remains a key concern for the Fed. A softening in labor market data would lift the likelihood of a protracted Fed pause and eventual rate cuts.

In our view, sharply higher rates, persistent inflationary pressures and tighter bank lending standards ultimately will weigh on the labor market and broader U.S. economy. Therefore, we believe U.S.Treasury yields have probably peaked, and we expect them to start moving lower as the economy stalls. This outlook explains our current preference for U.S. bonds — and why we’re optimistic about the potential for non-U.S. bonds in coming quarters.

Figure 1 illustrates the five-year paths of 10-year global government bond yields. The U.S. has outpaced its European peers, whose bond yields will likely rise further on persistently higher inflation rates.

More Rate Hikes in Europe May Present Bond Opportunities

Due to sustained higher inflation and slower monetary tightening strategies, we expect further rate hikes from the ECB and the BoE. Because of this, we believe bonds in these regions are less attractive than U.S. bonds. With rates still likely to rise, bond prices should fall further.

But we also believe an inflection point is coming. With additional tightening, inflation should moderate, and bond yields in Europe and the U.K. will eventually peak. In our view, this dynamic highlights the next opportunity for global fixed-income investors, as economic weakness ultimately forces the ECB and BoE to cut rates.

Eyes on Bond Holdings in New Zealand, Canada

While markets focus on the progress of the Fed and its European peers, other central banks have quietly surpassed the Fed in the inflation fight. We believe this should bode well for bond holdings in these countries.

For example, the Reserve Bank of New Zealand was among the first central banks to raise rates after the pandemic. It started hiking in October 2021 (five months before the Fed) and hit a terminal rate of 5.5% in May. The New Zealand economy is now in recession, which we expect to prompt central bank rate cuts.

We also see opportunities in Canada, where central bank policy appears to be further along than U.S. policy. Officials held rates steady from January to June when they hiked another quarter point amid persistent inflation (3.4% in May) and stronger-than-expected economic growth.

Canadian central bankers raised rates another quarter point in July and now seem poised to end their campaign as June inflation fell to 2.8%. The nation’s finance minister remains optimistic, declaring Canada better positioned than any other country for a soft landing. She recently told reporters, “We are very close to the end of this difficult time and to a return to low, stable inflation and strong, steady growth.”¹

U.S. Dollar Weakness Lifts Bond Prospects in Emerging Markets

As U.S. interest rates reach their peak levels, we expect the U.S. dollar to weaken versus other currencies. For emerging markets (EM), a weaker greenback would be welcome news.

Many EM countries and companies borrow in dollars. Lower funding costs for these debt issuers would broadly boost the attractiveness of EM bonds. Additionally, many EM central banks acted early to crush inflationary pressures, leaving their economies positioned to potentially outperform their developed markets peers.

Active Management Matters

Global economies’ changing dynamics present challenges for fixed-income investors, but we believe they also create opportunities for active fixed-income portfolios. Backed by the insight and experience of professional, seasoned investors, such strategies are attuned to market opportunities and risks. They have the flexibility to respond to changing market and economic conditions and explore worldwide investment opportunities beyond those of a broad market index.

We believe these characteristics may enhance performance potential and curtail risk throughout the economic cycle. But these qualities remain particularly important as cycles downshift at varying speeds.