Implied interest rates are overshooting their inflation targets and are beginning to look too restrictive to the point of being wrong, according to Aegon Asset Management.
Sandra Holdsworth, head of rates at Aegon AM, says this is leading to a repricing in markets that is overshooting sensible levels – leaving opportunities available to investors.
“Bond markets are already discounting increases in rates to levels not seen since before the financial crisis of 2008,” she says. “In the UK in particular, the bank rate is already at 1%. In the UK, the market is implying through the yield curve that the bank rate will peak at around 2.25%, in the US around 3% and in Europe 1.5%.
“As inflation has risen, expectations for monetary policy have followed. The same curves at the beginning of the year were not discounting such a profile. In a comparison of market expectations for policy rates by the end of 2023 as of today, and at the start of the year, we can see that repricing of curves has occurred everywhere, but most in the US.
“What investors will be looking at now is whether this repricing has overshot or has further to go.”
Holdsworth says the Bank of England is already forecasting this overshoot in its latest reports, and that implied rates are already looking too restrictive for the UK economy.
“Some guidance on this may have come from the recent Monetary Policy Report from the Bank of England which makes economic forecasts on the basis of market implied interest rates. The market implied level of rates would lead to a year of negative UK GDP growth in 2023 and inflation to falling well below target in three years time. This would suggest that in the bank’s opinion the market level of implied rates will be too restrictive for the UK economy.
“The most recent economic data would appear to confirm this outlook. For example, GDP in Q1 was disappointing, showing the economy contracted in March and was weaker for the quarter as whole than expected. Industrial and manufacturing contracted in both February and March. Business surveys are softening and retail sales falling along with consumer confidence. More positively though, the labour and housing markets remain firm.”
Holdsworth believes the outlook is now beginning to diverge between major economies, with the UK, US and EU all taking different routes through the inflation issue, implying different comfortable levels for rates.
“In our view there is room for market implied rates in the UK to fall, assuming that there are no further shocks regarding energy/oil prices, which remain a significant driver of inflation pressure.
“The US FOMC in its March communication had a more optimistic outlook. The median committee forecast for inflation was a return to 2.3% by 2024 without causing a recession and the median estimation of peak level of rates is just below the market implied forecast at 2.75 %. The FOMC will be updating forecasts again in June so markets will get more guidance as to its thinking regarding the appropriate level of rates.
“The US economy remains robust with a strong labour market. Some signs of concern are creeping into business surveys but on balance it is probably still too early to oppose market implied rate levels especially given recent strong inflation data and the current guidance from the FOMC.
“In Europe, the ECB has not started to raise rates and has provided little guidance as to appropriate levels. Again, the economy remains robust with employment growing and fiscal policy supportive. The ECB is expected to start to tighten policy in the H2 2022 and in this early stage we would not expect to get much guidance from the ECB.
“Unless the economy begins to show significant signs of weakness, we would question an opposition of current market levels.”