War in Ukraine unlikely to deter Fed and central bank peers from raising rates in March

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The US Federal Reserve and some of its major central bank counterparts will continue to hike interest rates this month, money markets suggest, even as a war on Europe’s eastern flank complicates the economic picture. inflation and economic growth.

The situation is fluid, with interest rate futures and bond prices being mowed down by conflicting impulses and no indication of what might take over: a war that threatens to undermine a global economic recovery, or inflation triggered by a spike in oil prices that will be hard for central bankers to overlook.

Yet expectations of big bets on higher rates were abandoned, following Russia’s invasion of Ukraine and sanctions imposed by Western powers.

The ensuing bond rally, also caused by an influx of cash in search of safety, took German 10-year yields below 0% on Tuesday, while their US counterparts fell some 30 basis points from at levels of 2% and over for two weeks. since.

Wednesday brings the first real test of March when the Bank of Canada (BoC) is expected to stick to its guns and offer a quarter-point rate hike — its first since 2018.

The Bank of Canada has pledged to show “force” in the fight against inflation, which is reaching 30-year highs of just above 5%. Markets see a 90% chance of a 25 basis point increase this month.

The five to six price increases for 2022 are slightly less aggressive than a few weeks ago, when six to seven moves were expected.

The Federal Reserve and the Bank of England (BoE) are also expected to raise rates by a quarter point in mid-March. But before the Ukraine crisis erupted, markets saw a strong likelihood that the two would opt for half-point moves.

Money markets now expect less than six Fed rate hikes of 25 basis points in total this year, compared to expectations in mid-February for a total of 175 basis points of tightening.

Jim Caron, chief fixed income strategist at Morgan Stanley Investment Management, called the latest events a “double-edged sword,” given the inflationary threat from rising oil prices and the possible impact of war on economic growth.

“There was a recalibration of rate expectations and that became very apparent with the pricing of a 50 basis point (Fed) hike for March,” Caron said, referring to a 50 basis point hike. . “So the question becomes trying to figure out what this means for the Fed.”

The dilemma is less acute for the Fed than for its European peers, given that Russia-related growth setbacks are less likely in the United States. And inflation in the United States is at its highest level in 40 years, above 7%, while the latest data shows that the number of unemployed has fallen to levels last seen in 1970.

The UK faces a similar inflation dilemma, with the added complication of an energy-related impact on growth.

On Tuesday, rate hikes of 25 basis points were almost fully priced in for the BoE’s March and May meetings, although markets now see around a 10% chance it won’t tighten policy this month – an element of doubt that has only recently crept in.

A total of four quarter-point rate hikes are now priced in for 2022, up from five at the end of last week and six in mid-February.

“Different central banks are in different boats, but the Fed and the Bank of England have their backs to the wall,” said Mizuho senior economist Colin Asher. “When inflation is 6% to 7%, inactivity is not an option.”

Britain’s annual consumer price inflation (CPI) hit 5.5% in January, its highest level since 1992. While the BoE expects the CPI to peak at around 7.25%, Citi economists estimate it could reach 8.1%.

UK government bonds have reacted far more than money markets, with two-year yields down 40 basis points since Friday’s close at around 0.8%. They hit an 11-year high of 1.565% on February 16.

The fall in yields since the announcement of sanctions against Russia is the steepest since just after the Brexit referendum in June 2016.

Norway is also expected to raise rates on March 24.

Prior to the Russian invasion of Ukraine, which Moscow calls a “special operation,” even accommodating banks were under pressure from inflation.

While the Reserve Bank of Australia held rates steady as expected on Tuesday, it hinted that war-induced uncertainty could be a reason to be patient in the face of tightening.

As for the European Central Bank (ECB), inflationary pressures are building – Germany’s CPI topped 5% in February – but so are economic growth risks.

ECB chief economist Philip Lane said the dispute could cut economic output in the euro zone by 0.3% to 0.4% this year.

As the bank braced markets for another cut in stimulus at its March 10 meeting, bets on higher rates are shriveling. Just under two 10 basis point moves are priced for 2022, down from 50 basis points shortly after the February 3 ECB meeting.

Finally, the rush to safe assets halted the rise in longer-dated Japanese bond yields – a headache for the Bank of Japan (BOJ), which is targeting 10-year yields in a range around 0%.

“The BOJ is no longer under pressure as things have moved in their direction,” Mizuho’s Asher said of the March 18 BOJ meeting.

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