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Friday 4th February 2022
Hi Friend,
Friday Forward Guidance ...
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| | The Saturday Economist Friday Forward Guidance ... This is our Friday Forward Guidance for Friday 4th February. Every week we update our scenario forecasts for base rates in the U.S. UK and Europe over a three year period. We also include our expectations for inflation, as an input to the central bank reaction function, in the Saturday Economist updates.
Our outlook changed this week. The MPC meeting was a game changer. Members voted 5 - 4 for a 25 point increase in base rate. Four voted for a 50 basis point rise. Dave Ramsden and the externals were the hawks. Catherine Mann, Jonathan Haskel and Michael Saunders wanted to push base rates to 0.75%. It seems likely rates will rise by a further 25 points when the committee meets again in March.
The committee also agreed the Bank would cease to reinvest any maturities from the stock of UK bond purchases. This reflected the intention to reduce holdings of government bonds in a "gradual and predictable manner". The Bank will also dump the £20 billion holding in corporate bonds. No one can quite remember why they were bought in the first place.
UK ten year bond yields moved higher in the week, trading at 1.37 this morning for an up eleven point gain. U.S. ten year yields trade at 1.81 down 3 points.The big U.S. move is expected once the Fed purchases end in March.
U.S. equities were steady. Facebook dropped 24%. Sterling moved higher against the Dollar. Bitcoin trades at $37,700 dollars as we write. Don't miss The Saturday Economist out tomorrow. We take a hard look at the Bank inflation forecast. Don't miss Our Monday Morning Markets, out on Monday. We reckon US markets remain some 15% over extended ... More Pain to Come? Perhaps ...
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| | Fed Funds Rate ...
The Fed statement last week confirmed the economy and the employment outlook continue to strengthen. "The committee expects it will soon be appropriate to raise the target range for the fed funds rate". The first hike expected in March. Forward contracts January 2023 are trading with an implied yield of 1.25%.
We now expect a 50 point hike in March, with two or three possible increases through to the end of the year. The Fed funds rate will close at 1.25% on our more hawkish scenario.
Markets steadied this week. Facebook and PayPal grabbed the headlines with a 24% drop. Ten year bond yields trade at 1.81 this morning. Next the test of 2.00 and 2.50. We expect the big moves once the Fed stops buying in March.
We expect three to four base rate hikes from end of Q1 onward, closing at 1.25%, rising to 2.50% by the end of
2025. The projections remain broadly in line with the FOMC December
Blue Dot Plot. This is our "We are leaving Planet ZIRP" scenario. Grab a ticket for the flight, don't forget the cancellation insurance.
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| Fed Funds Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.10% 1.25% 1.50% 2.00% 2.50% 3.50%
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| | Bank Base Rate...
Big moves from the MPC. The committee voted to increase base rates by 25 basis points this week. It could have been higher. Four members wanted a 50 basis point rise to 0.75%. The governor held the casting voted, opting for a step by step approach. Inflation is expected to peak at around 7.25% in April.
It seems clear rates will rise by a further 25 point move in March. We now expect rates to end the year at 1.25%.
Ten year gilts trade at 1.37 up eleven basis points. Next the test of 1.50 then 2.00. Sterling trades higher against the Dollar at $1.3557. The market-implied path for Bank Rate hits 1.25% by Q1 of 2023, then 1.50% by the middle of the year.
We assume the pattern of rate hikes, will close at 1.25% in the final quarter this year. We expect more to follow in 2023, pushing to 1.50% at close. The MPC is committed to the great escape from Planet ZIRP.
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| Bank Base Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.25% 1.25% 1.50% 1.75% 2.50% 3.50%
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| | Euro Base Rate...
Inflation in the Euro Zone hit 5.1% in January up from 5.0% in December. Christine Lagarde, President
of the EU Central Bank still suggests European rates could stay on
hold through 2022.
Lagarde has rejected calls to raise rates more quickly. The bank had "every reason not to act as quickly or as ruthlessly as the Federal Reserve". Rising rates too quickly would "put the brakes on growth" she said. "Higher inflation in the U.K. is partly a result of Brexit".
The Euro trades at $1.15 against the Dollar up from $1.11 last week. If our expectations for US
and UK rates hold, we would Euro rates could close at 0.25% by the end
of 2022 at least, to avoid significant pressure on the Euro. It could well be higher closing at 0.50%.
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| ECB Base Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.00% 0.25% 0.50% 0.75% 2.50% 3.50%
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| | | Scenario Comparisons ...
This is the table of scenario comparisons. We would expect UK rates to lag not lead the US pattern. EU rates would follow the US/UK lead. Inflation may subside sooner than expected. Central banks may worry about the shock to growth. Russia may step over the border into Ukraine. The escape from Planet ZIRP could be aborted. This is a scenario not the plan.
Our modified Taylor rule suggests the UK central bank is behind the curve on rate hikes. In our modified Taylor rule we model base rates as a function of inflation variance from target and the output gap relative to trend growth. The implication is base rates should close the year at 1.25% in 2021 and by 1.50% by the end of 2022. This is a benchmark not a forecast!
We model the long run rate at 3.50%. The Fed Blue dot projections assume 2.50% as the perceived long run rate. In the UK, prior to the Great Financial Crash [2000 - 2008] the average inflation rate was 2.0%, the average UK bank rate was 4.50%. Ten year bond yields averaged 4.50%. Some way to go yet!
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| | That's all for this week's Friday Forward Guidance. Don't miss the Saturday Economist Out Tomorrow ... and our Monday Morning Markets out on Monday ...
"To understand the markets, you have to understand the economics"
John
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