Following key central bank policy meetings last week in Australia, the US and UK, short-end interest rate markets have turned more dovish. We had argued back on 2nd November that “hawkish interest rate markets may have got slightly ahead of themselves.”
The Federal Reserve and certainly the RBA cooled market expectations of rate hikes while the Bank of England flat-footed markets by leaving its policy rate unchanged at a record-low 0.10%. This was in line with our view that the Fed would “once again put some distance between the start of the QE taper and the start of the rate hiking cycle.”
Within developed economies only the RBNZ and Bank of Canada have so far ended their asset purchases and only the Norges Bank and RBNZ have hiked their policy rates (by 25bp each) since the pandemic struck 20 months ago. In comparison 10 out of 21 major EM central banks have hiked their policy rate at least once in the past six months.
The spread between the EM and developed economy central bank policy rate, which had narrowed from about 413bp in March 2020 to 360bp last summer, has thus since widened to a 3-year high of 423bp. The pattern was similar following the Great Financial Crisis.
Monetary policy tightening is proceeding more slowly in developed economies despite headline CPI-inflation rising to a 13-year high of 3.9% yoy in September while in EM it was stable at 3.3% yoy. EM central banks, at least as a whole, have got a handle on inflation.
As a result in developed economies the central bank “real” policy rate collapsed to a multi-decade low of -4.0% at end-September, compared to +0.8% in EM. Excluding India and China the EM central bank real policy rate was still -2.0%, or twice as large as the GDP-weighted real rate in developed economies.
This divergence in real policy rates partly explains why EM currencies have outperformed developed currencies since late-April, in our view.
If the gap between developed and EM CPI-inflation continues to widen we think developed interest rate markets may once again find it difficult to buy into these central banks’ ultimately dovish thinking and short-end government yields may start to rise again.
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