Central Banks Compelled To Hold Tight

  • Sticky inflation is leading major central banks to keep policy tight. We prefer emerging market debt as policy loosens and like short-dated bonds for income.
  • Developed market short-term bond yields jumped after central banks signaled more rate hikes to come. We see rates staying higher for longer.
  • This week’s PMIs will help gauge how much rate hikes have cooled activity. We already see signs of a mild recession in the U.S. and euro area.

Sticky inflation looks to compel developed markets (DM) central banks to crank policy rates higher – and keep policy tight for longer. The Federal Reserve paused last week but pointed to more hikes on the way. The European Central Bank (ECB) raised rates and made clear it wasn’t done. Others hiked after earlier pauses. We prefer emerging market (EM) debt due to looser policy potential, like recent rate cuts in China. We also like income opportunities such as short-dated bonds.

Jobs growth disconnect

Labor shortages are fueling wage growth, keeping core inflation elevated. That has led the Fed to double down on a “whatever it takes” approach to fighting inflation: Last week it signaled more hikes in the same meeting where it paused. This is happening as central banks in Australia and Canada resumed hikes after attempted pauses – and as the ECB hiked again. We think the Fed and ECB appear to be underappreciating the existing damage from hikes. The Fed revised its growth forecast based on historically low unemployment. The Fed may be relying on a job and growth relationship that has broken, in our view. Labor shortages have made firms reluctant to let workers go, even as demand slows, and growth stagnates. That has made job growth look resilient (orange line in the chart) in recent months compared with weaker jobs data in past recessions (gray lines), even as some data suggest recession may have already arrived.