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Why markets jumped as central banks turned hawkish: Explained

Lewis Jackson  |  17 Dec 2021Text size  Decrease  Increase  |  
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All year, investors have been warned about the risk inflation poses to equity markets. Left unchecked, so the argument goes, rising prices would force central banks to “slam on the brakes”, hiking interest rates and cutting short the bull market.

So, many were left scratching their heads when markets rallied this week in response to hawkish pivots from central bankers in the UK and US. The US Federal Reserve signalled three rate hikes in 2022 following its board meeting on Wednesday. A day later in London, the Bank of England raised rates for the first time since the pandemic began. The S&P 500 and the FTSE 100 rallied in response.

What’s going on? We spoke with several analysts and economists to unpack the market’s reaction, and what rising rates overseas mean for the Reserve Bank.

What happened

The US Federal Reserve is moving to head off surging inflation by accelerating the end of its multi-billion-dollar asset purchase program and indicating three rate hikes could follow.

The Federal Open Market Committee (FOMC), which makes interest rate decisions, voted on Wednesday to reduce the size of monthly asset purchases. The program, which buys bonds and mortgage securities off institutional investors in the hope they’ll invest the proceeds elsewhere, is now expected to end in March next year, three months earlier than previously scheduled.

The FOMC’s members also signalled rate hikes for the new year. All 18 now expect a rate hike next year, with two-thirds pencilling in at least three. In March, just four members expected a rate hike in 2022.

“Perhaps the biggest surprise was how hawkish the rate-hike projections turned,” says Eric Compton, senior equity analyst at Morningstar.

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Wednesday marked an inflection point in the Federal Reserve’s assessment of inflation. For months, the central bank insisted rising prices would fade with the pandemic and resisted tightening policy as it shepherded the economy recovery. A strong rebound in growth and employment and hard-to-shake inflation forced a rethink.

“We think the Fed is signalling that it is taking inflation seriously now. After coming across rather dovish for the past several years, the Fed believes inflation is here to stay for a while and the time has come for a hard pivot,” says Eric Compton, a senior equity analyst at Morningstar.

It’s not alone. The Bank of England raised interest rates for the first time since the pandemic began after its meeting on Thursday. In New Zealand, the central bank has lifted rates twice since October as it battles to bring inflation and house prices under control.

Why did markets jump in response?

Markets reacted with equanimity in part because the moves were well telegraphed ahead of time, according to several analysts who spoke with Morningstar. The rallies also reflect the belief that tighter policy sooner could curb inflation without overly hurting growth and equity markets.

The S&P 500 rose 1.6% after the Fed’s meeting, closing near a record. The tech-heavy Nasdaq, filled with stocks more sensitive to interest rate changes, surged 2.15%. A day later in London, the FTSE 100 responded to the Bank of England’s decision by rallying 1.3%.

“Because they’d telegraphed the moves so well there was a relief rally. It was no worse than we’d thought,” says Morningstar’s head of equity research Peter Warnes.

The clear signals are the Fed’s way of avoiding the “taper tantrum” of 2013. Then, markets sold off in response to an unexpectedly hawkish shift in policy from the central bank.

Investors are also hoping aggressive moves today could remove the need for steep and sudden rate hikes later, says Stephen Miller, an adviser at GSFM funds management. Long-term bond yields should stay subdued with inflation under control, supporting equity market valuations.

“It’s the old stitch in time saves nine. By moving modestly and having three rates next year, markets are now of the view that the Fed is on top of this. We probably won’t need to worry about inflation as much as we do,” says Miller.

Central banks face a difficult balancing act nonetheless, with the shift to tighter policy underway as the Omicron variant spreads. US markets reflected that uncertainty a day later, when the S&P 500 fell 0.9%, reversing some of the gains it notched following the Fed’s decision.

A new debate looms in 2022

The move to tighter policy brings the “transitory vs persistent inflation” debate to a close while introducing a new issue for 2022.

On the one side are those concerned markets are overestimating the ability of central banks to bring inflation under control. Miller believes there’s a real possibility these moves in the UK and US fail to curb inflation and more rate hikes are needed.

“I worry that the Fed might have to do more, and that inflation will go higher than the Fed and markets currently think it will,” he says.

Others worry higher rates could hurt growth and destabilise debts. Interest rates control inflation by slowing the economy, making borrowing pricier and reducing wealth via lower asset prices. Go too far and growth slides seriously. Historically high debt levels mean rising rates could push many borrowers into stress.

“We still think the Fed will have to 'thread the needle' once into 2023, balancing a retreat in inflation with higher debt loads and what is likely to be a cooldown in economic growth,” says Compton.

Pressure on the Reserve Bank

This week’s decisions will add pressure to a Reserve Bank whose dovish stance is increasingly out of place among its hawkish counterparts overseas.

The first casualty could be the RBA’s bond purchase program, says Peter Tulip, chief economist at the Centre for Independent Studies, previously of the Reserve Bank and Federal Reserve.

The RBA’s multi-billion asset purchase program was partly motivated by a desire to match its counterparts overseas, he says. The end of bond buying at the Fed removes that justification.

“As the Fed winds up its purchases that removes one of the leading reasons the RBA had for active purchases. It moves us closer to the end of quantitative easing,” he says.

The bank will consider the program’s future at its February meeting, at which point the bank will hold $350 billion in state and federal government bonds.

For now, the RBA insists rates will not follow anytime soon. The bank left interest rates on hold at its December meeting saying they won’t rise until inflation is sustainably in the 2% to 3% target range. The bank expects its preferred measure of inflation to hit 2.5% sometime in 2023.

Still, higher rates overseas could leave the RBA looking “behind the curve”, says Tulip. That could put external pressure on the bank to act.

“Central bankers often see themselves as in competition, sometimes in a race. None of them like to be perceived as being behind the curve,” he says.

“From a public relations point of view there is a pressure on them to move together.”

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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