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Markets seek certainty that policy will succeed


Commentary by: Jumana Saleheen, Vanguard Chief Economist, Europe

Elevated volatility is a key feature of markets today. The United Kingdom saw some particularly sharp moves in late September in response to a fiscal policy announcement known as the mini budget. The volatility created havoc in an unexpected place—the domestic pensions sector—and only a timely Bank of England intervention prevented a crisis that might have spiraled beyond U.K. borders.

The proposed mini budget raised investors’ concerns about future inflation and U.K. debt sustainability. In response, sterling fell against the dollar and euro, and bond prices fell across a range of maturities. The speed at which bond prices fell exposed vulnerabilities in strategies that certain pension funds had used to manage their balance sheet. It forced them into bond sales amid margin calls.

The near-crisis appears to have abated after a new chancellor was appointed and the government reversed course on much of the mini budget. But it is worth stepping back and considering why markets are volatile. A combination of factors has contributed, including the strong post-COVID recovery and tight labor market, the war in Ukraine and European energy crisis, and central banks’ efforts to tackle multidecade-high inflation. To return inflation to their 2% target, central banks in the United States, the euro area, and the U.K. have communicated the need to continue raising rates in earnest, such that high inflation does not become embedded into the economy. 

Rising expectations for central bank interest rates 

Notes: Market expectations for central bank policy rates at a given time are represented by one-month forward swap rates. U.S. swaps are based on published overnight federal funds rate indexes. Euro area swaps are based on the published euro overnight index average. U.K. swaps are based on published overnight bank rate indexes. Neutral-rate ranges are Vanguard estimates. The neutral rate is the level at which policy interest rates would neither stimulate nor restrict an economy. Estimates of the neutral rate are determined by long-term economic factors and are subject to a wide band of statistical uncertainty. Estimates of the nominal neutral rate assume inflation of 2% in the United States, 1.8% in the euro area, and 2% in the United Kingdom. The Vanguard terminal rate is our view of the level at which central bank policy rates will peak during their interest rate tightening cycle. 

Source: Vanguard analysis, as of October 14, 2022.

Interest rates have increased rapidly over the past six months, and that pace is expected to continue. The charts above show expectations for how high rates will go. They are significantly higher now than they were last month, particularly for the Bank of England. And they are materially higher than where they were at the end of last year. Our view is that policy rates in these major economies will continue to rise into March 2023.

Vanguard believes that central banks will adhere to their inflation-fighting paths unless “something breaks”—an economic sacrifice or market threat beyond the controlled slowdown they are trying to engineer. Of course, the path of policy will depend on future events and data outturns. In our recent Global Macro Matters research Getting Inside the Fed’s Head, we discuss how good luck with respect to energy prices, inflation expectations, and labor markets could result in a lower terminal rate of interest. A series of unlucky shocks, however, may give rise to a higher terminal rate. 

This extraordinary economic environment breeds volatile conditions that can spread to distinct parts of the market, broadly increasing risk. Where, when, and even whether other such crises-in-waiting may materialize isn’t clear. In recent weeks, debates have arisen about the fundamental health of a major European bank and a sovereign European nation.

Investors need to understand that financial markets may face continued shocks until they find their footing. That’s why markets are so keen to nail down the final destination for the global macroeconomy. Can major central banks navigate the economy’s return to a world of low and stable inflation, a world we know well and desire? If so, what will it take to get us there? 

What is turning into a sprint toward the terminal interest rate reflects policymakers’ sincere belief that, by acting decisively, they can bring us back to that comfortable world. Fragilities in the U.K. pension sector were a wake-up call that the journey will be bumpy. Markets struggle with those bumps. They crave the certainty that policymakers are poised to succeed. And these days, certainty is in short supply.



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