Article
Central banks around the world are aggressively raising interest rates to curb the highest levels of inflation seen in decades, tightening financial conditions and increasing market volatility. Yet, for investors, the future may be even more uncertain because the economic trajectories of the world’s largest countries are now diverging.
March 31, 2023
The great experiment of sustained low interest rates is coming to an end.
Aggressive policy rate hikes complicate the economic story for the world’s largest economies – further adding to interest-rate volatility.
In this volatile environment, favor actively managed fixed-income strategies. Investors should also consider defensive equity strategies that are less correlated with the broader market.
Central banks are aggressively raising rates while economic fundamentals are diverging
Central bank policy rate paths
(in%)
Note: Rate path taken from consensus economist forecasts on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
The great experiment of low interest rates looks like it is about to end. Amid higher inflation and quick economic recoveries, central banks in the world’s largest economies – except China – have hiked rates for the first time in years, and many have raised them to the highest levels in recent memory. Many investors expected a repeat of the aftermath of the Great Financial Crisis (GFC), when inflation and policy rates remained at ultralow levels for the foreseeable future – after all, long-term economic drivers did not materially change from 2009 to 2021. And yet, supply-chain snarls, an accelerated recovery of the employment market, and a war in Europe brought global inflationary pressures to a boil; headline inflation rates in many economies shot past their central banks’ targets and stayed stubbornly high throughout 2022. The inflation that was missing after the Great Financial Crisis came back with a vengeance.
These are uncharted waters for many investors. In the past, the US Federal Reserve used to blaze the trail of rate hikes globally, with a cadre of central banks following its lead. Today, the world’s largest economies are experiencing idiosyncratic and divergent economic fundamentals, leading to different rate paths and varying degrees of confidence about the path forward.
US fundamentals heatmap
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
Fed’s possible policy-rate trajectories (in %)
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
Confounding pessimists, economic momentum in the United States has remained surprisingly resilient. The latest GDP report showed growth beating expectations and averaging out to around a 3% annualized rate in the second half of 2022, far higher than the 2.3% average seen during the post-GFC recovery. Growth expectations have also improved, with the International Monetary Fund (IMF) upgrading its growth forecast for 2023 in its latest World Economic Outlook. Economists polled by Bloomberg have lowered their expectations of a recession regardless of the yield curve.
The employment market in particular has remained a remarkable pillar of strength. Despite headlines about several stressed sectors announcing layoffs, the US unemployment rate remains the lowest in decades, and the economy is the closest to “full employment” that the Federal Reserve has seen in recent memory. Perhaps even more impressively, job growth is still vibrant, fueling the continued surge in retail spending and inflationary pressures.
The flip side of better-than-expected growth and a hot labor market is their impact on inflation and interest rates. Inflation has moderated in the United States, and the peak yearly rates are likely behind us. But underneath the headline picture is a worrying picture for the Federal Reserve. Although the pressures from inflation components like energy costs and other commodities have sharply declined in recent months, services inflation excluding energy, a so-called “sticky” form of inflation since its effects tend to linger, is running at a pace more than twice as fast compared to its pre-COVID trend.
Given these underlying fundamentals, we assign a high probability to the Fed’s base case and assign a slight overweight to the dovish (scenario for lower than expected interest rates) case compared to the hawkish (scenario for higher than expected interest rates) case in the event that inflation eases faster than expected. As a result, the rate path for the Federal Reserve is very clear: higher before pulling back closer to the Fed’s terminal rate of 2.75%. Though the path is narrow, the Fed looks like it can deliver a “soft landing” after all.
Europe fundamentals heatmap
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
ECB's possible policy-rate trajectories
(in %)
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
Most policymakers would say that stagflation – an environment of sluggish growth and high inflation – is the most undesirable and difficult economic environment to emerge from. And that’s precisely what policymakers in Europe are facing. In contrast to the underlying strength seen in the United States, growth in Europe is expected to dip into contraction territory during the first half of 2023. Even with a milder-than-expected winter, Germany, the Eurozone’s largest economy and growth engine, reported that its GDP fell short of expectations in Q4 2022 and is on track for two quarters of consecutive contraction by the end of Q1 2023 thanks to combined pressure of high interest rates and high energy prices.
Labor markets also aren’t showing the same type of strength compared to that of the United States. Germany’s unemployment rate – one of the lowest in the Eurozone – rose in the second half of 2022 and, at 5.5%, remains much higher than the 3.4% seen in the US. Other economies in the euro area, like Greece, are still showing an unemployment rate above 10%, which makes any rate-hike decisions by the European Central Bank difficult because the cure for high inflation may come at a dear cost for Eurozone economies that are already in weak shape.
Adding to Europe’s woes is a more severe inflation problem. Although the yearly pace of inflation has declined over the past few months, inflation is running faster than in the United States and is much closer to 10% than to the ECB’s 2% target. As a result, the probability of higher-for-longer interest-rate levels in the euro area is relatively high, which is a marked difference after years of a zero-to-negative interest-rate policy after the Great Financial Crisis.
UK fundamentals heatmap
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
BOE's possible policy-rate trajectories
(in %)
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
Growth in the United Kingdom is even more problematic. The UK reported its quarterly real GDP growth rate at or below zero for the second half of 2022, and growth expectations have also dimmed. Despite many upgrades for other developed nations in its most recent forecast, the IMF downgraded its 2023 growth forecast for the UK. Forecasters now expect a recession to occur in the face of historic labor disputes, high interest rates, and very painfully high inflation.
The one bright spot in the UK’s economy may be its low unemployment rate. But other labor market indicators show a mixed picture. Unemployment claims are stuck at a far higher level than their pre-COVID trend, which surely is not a sign of a tight labor market, and the labor force participation rate remains well below the average of the past two decades. Brexit has also made it more difficult for UK firms to source labor from other parts of Europe, adding to the challenges the economy faces.
In this stagflationary environment, we assign 50% odds that the Bank of England will follow the path expected by forecasters and investors, with rates peaking between 4% and 5% in 2023 before falling in 2024 with a dovish tilt if inflation or growth slow more than expected.
China fundamentals heatmap
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
PBoC's possible policy-rate trajectories
(in %)
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
In China, growth and inflation are more supportive of a lasting accommodative monetary policy in sharp contrast to the central banks in the West. While a recession in China is far more unlikely, the growth rate there is expected to stay at a moderate pace. Inflation remains below target, and various labor market indicators are not showing an environment of full employment.
We therefore have a strong conviction that policy rates will not change significantly in China in the medium term.
Japan fundamentals heatmap
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
BOJ's possible policy-rate trajectories
(in %)
Note: Base case derived from consensus of economists polled on Bloomberg
Source Bloomberg, Credit Suisse Asset Management as of March 1, 2023
Like our forecast for the People’s Bank of China, we do not expect to see significant changes to the Bank of Japan’s interest-rate policy either. Japan’s current growth momentum and current inflation reading both can act as ammunition for hawks on the BoJ’s governing board. But the durability of those dynamics is questionable, especially because Japan’s headline inflation rate is much more influenced by energy and fresh food prices compared to other economies. We believe that the policymakers at the Bank of Japan agree, so we do not expect to see significant changes to the Bank of Japan’s policy rate in the medium term.
For investors, such an analysis surely complicates an already unusual post-COVID environment. Each of the major economies discussed has its idiosyncrasies personified in wildly different conviction levels for the medium-term policy-rate path. Given the moderate growth and high inflation readings in the West, we expect yield curves to stay inverted for some time, which can distort the plumbing of financial markets. For major Asian economies, the rate path is clearer, but the durability of China’s and Japan’s economic recovery is more of a question mark than that of the United States. In this environment, we expect bond markets to be highly data-dependent and likely more volatile than they were during the post-GFC business cycle.
Such an environment breeds uncertainty and volatility. For example, the Credit Suisse interest-rate volatility index is trending at an unusually high level outside a recession and may stay elevated for some time. Investors should consider pursuing active fixed-income strategies that invest in high-quality companies or defensive equity strategies that are less correlated with the broader market.
Historical performance indications and financial market scenarios are not reliable indicators of future performance.
Credit Suisse Interest Rate Volatility index
Note: Latest point is February 2023
Source Credit Suisse Asset Management as of March 1, 2023
Historical performance indications and financial market scenarios are not reliable indicators of future performance. It is not possible to invest in an index. The index returns shown do not represent the results of actual trading of investable assets/securities. Investors pursuing a strategy similar to an index may experience higher or lower returns and will bear the cost of fees and expenses that will reduce returns.
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