By all means

Financial markets continue to be in a rollercoaster of emotions. March, for example, seamlessly followed the turbulent first two months of 2022. The tragedy surrounding the war in Ukraine is creating a high degree of uncertainty and investors are caught between hope and trepidation. On the one hand, hope always germinates when the warring parties announce direct negotiations, and on the other hand, any disappointment ensures a further rise in commodity prices, which in turn increases inflationary pressure. 

Last week, the focus of attention was primarily on the US central bank. With the first interest rate step of a quarter percentage point, the Federal Reserve (Fed) has now initiated the interest rate turnaround and is now devoting itself mainly to the task of fighting inflation. Given an inflation rate on a 40-year high, this seems to be a herculean task (graph 1). 

Clear focus on fighting inflation

There were no surprises on the part of the Fed last Wednesday. The interest rate hike was well communicated in advance and capital markets had time to adjust to it and also to anticipate further interest rate steps. However, the press conference of Chairman Jerome Powell that followed the Fed’s monetary policy decision was quite interesting on closer inspection. In our view, the following three points are crucial for investors:

Strong US economy: in his remarks, Powell emphasized the solid state of the world's largest economy and pointed to the healthy household balance sheet and rising wages. What was not addressed, however, was the deterioration of US consumer confidence. While wages have risen in nominal terms, real wages have not. This could well become a sticking point for the Fed. It is also noticeable that the central bank has significantly reduced its growth forecast for 2022 to 2.8% from 4.0%, in its December 2021 projection. 

Private companies: Even with a less expansionary monetary policy, the private sector can flourish. This seems a bold statement to us, as a restrictive monetary policy will also make financing conditions more demanding, which is likely to create headwinds for many companies. 

Price stability at any price: The Federal Open Market Committee (FOMC) will focus “by any means necessary” on restoring price stability. Given the current high inflationary pressures, this could mean that the Fed would have to raise Fed funds rates above the targeted long-term level of 2.5-2.75%. The first central bank members have already expressed a possible range of 3.5-4.0%. Although capital markets have factored in ten interest rate steps of 25 basis points each over the next two years, an increase to over 3.0% would certainly be a surprise. Such a rate hike cycle will put considerable pressure on economy and put economic growth at risk. However, the Fed has not yet communicated what we consider to be the most important point, namely when and at what pace it intends to reduce its balance sheet. 

Will the ECB follow up on monetary policy turnaround?

The European Central Bank (ECB) will also (have to) raise interest rates in the foreseeable future. Investors expect a first rate hike of ten basis points as early as in the next four to six months (graph 2).

With an inflation rate at almost 6% and the risk of further energy price increases, the ECB seems to have little choice. For 2022, capital markets have already factored in five interest rate steps of ten basis points, but this would only raise the ECB's deposit rate to zero percent. 

The conclusion is clear, the most important central banks on both sides of the Atlantic – the Fed, the ECB and the Bank of England – have declared war on inflation. The consequence is rising interest rates and a diminishing supply of liquidity to financial markets. But the big unknown remains how quickly the Fed will reduce its balance sheet and how much the impact of the conflict in Ukraine and the confrontation with Russia will weigh on global economic growth.

Monitor risks closely

Fighting inflation in Western countries remains the key challenge as we look ahead to the second quarter. The war in Ukraine has tended to increase inflationary pressures as certain supply chains are likely to be disrupted for longer. At a portfolio level, investors should keep risks in check and exit “suboptimal” risk positions, such as technology companies (that are not generating profits) following the recent rally. Likewise, risk positions on the bond side, for example in the high-yield area, should be closely scrutinized. For the moment, we continue to hold sufficient liquidity in our portfolios and would accumulate gold in any weak phase.