Uncomfortable resilience

The stickiness of inflation in the United States suggests the global inflation pulse is stronger than many had hoped.

ANZ Research has upwardly revised its forecasts for peak-cycle monetary policy rates in the US (now 5.0 per cent), New Zealand (4.75 per cent), the European area (3.0 per cent), the United Kingdom (4.0 per cent), India (6.5 per cent), Malaysia (3.5 per cent), Philippines (5.25 per cent), Korea (3.5 per cent), Thailand (2.5 per cent) and Indonesia (5.75 per cent). Vietnam is unchanged.

In Australia, ANZ Research is also considering whether additional hikes beyond its peak forecast of 3.35 per cent might be required. Only China is seen as easing and is Japan on hold.

To some degree, these revisions reflect spillover from ANZ Research’s hawkish view on the US Federal Reserve’s rates outlook.

Some central banks will be concerned about the inflationary implications of currency weakness against the US dollar. More broadly, the experience of the US itself – and other economies including the UK, Australia, NZ and Korea – is rate hikes have had much less impact on labour demand than expected.

Housing indicators have weakened in line with higher rates, but outside China there has been no general increase in unemployment rates or decline in job vacancies. This is good news for people, but a challenge for inflation and monetary policy.

ANZ Research’s new forecast 5.0 per cent peak for the fed funds rate is substantially restrictive, raising the risk of a harder landing for the US economy. These risks are even higher given central banks have allowed policy to disconnect from economic improvement over 2020 and 2021. Opportunities to pause hiking to assess the impact of already delivered interest-rate increases are limited.

Growth forecasts for 2022 have been revised down. ANZ Research is forecasting a recession in the UK; and, with near-zero annual growth in the US and EA, shallow recessions are part of the profile now.

A delinquency cycle is likely. Those businesses that have been reliant on the post-crisis low global interest rate structure are likely to present risks.

Supply factors

It seems increasingly clear the bulk of the inflation challenge doesn’t reflect temporary supply factors. Shipping rates and commodity prices have declined, and even some of the last economies with movement restrictions, such as Japan and Hong Kong, are reopening.

Headline inflation in some economies has since declined, but core inflation has remained stickier than it should if transitory drivers were primary. Consequently, the end of the conflict in Europe, were that to occur at some point, might have only a relatively modest effect on global inflation.

China remains the main exception to the reliant economy and strong inflation narrative. Easing has become ubiquitous as headwinds have increased. An economy growing at 3 per cent this year and 4.2 per cent and 4.0 per cent in the next two years would be the weakest three-year period (outside 2020’s COVID crisis) since the 1970s.

China’s external accounts, with seven-consecutive months of debt capital outflows suggest much more hesitancy from foreign investors towards China as an investment destination.

Since entering the World Trade Organisation (WTO) in 2001, China has often been thought of in aspirational terms: the largest emerging economy, soon likely to overtake the US, the largest untapped consumer market, a long-term destination for cross border portfolio flows.

In many ways these expectations are waning. China’s economic growth has come back to the pack, estimates of structural growth have come down and portfolio capital has become less enamoured.

Volatility

Bond markets have been the most volatile, followed by FX and with equity a distant third. The volatility in bond markets is understandable. But the relatively low level of equity volatility doesn’t seem consistent with the deep and damaging recession that seems to be the central case for some. It’s hard to recall one ever occurring without the other.

When considering the potential for movement in bond yields, the period between the GFC and the pandemic is a poor template for the current period, in ANZ Research's view. In both periods the front end of the curve and the long end are highly correlated, but the source of information for forecasters has flipped.

In the pre-pandemic period, the long end often guided the front end. Fed expectations were often too hawkish, and it was the long end failing to sell-off as forecasters expected that eventually led front-end yields down.

But since the pandemic, accurately hawkish front-end expectations are guiding long-end yields higher. ANZ Research expects a more parallel sell-off in bond yields across the US curve than has been the case since the first half of 2021.

The curve is already inverted by as much as markets have seen since the early 1980s. One unique feature of this cycle is measures of future prosperity fell to levels normally associated with recession, very early in the interest-rate tightening cycle.

The Philadelphia Fed survey’s six-month expectations index for general business activity has fallen to the lowest level since 1979. Since mid-2021 the US Conference Board’s measure of consumer confidence expectations has shown a collapse relative to current confidence.

On one level the more the Fed hikes the more hard-landing risks rise, which might imply an even flatter yield curve. But the Fed is also hiking because the labour market is so strong, which suggests upward revisions to estimates of the long-run Fed funds rate.

As such, in ANZ Research's assessment, the trend to yield-curve flattening has run its course  For substantial steepening to occur, markets would typically need to see the bond market shift to pricing near-term Fed rate cuts. That pricing is not expected to emerge until later in 2023 at the earliest.

Richard Yetsenga is Chief Economist at ANZ

This story is an edited excerpt from the ANZ Research report “ANZ Research Quarterly: still higher interest rates”, published September 27, 2022