Hawkish Confidence gives way to Data Dependency

We heard from all three major central banks in the last month, and it is becoming increasingly clear that we are approaching a pivotal moment in the inflation fight and what that means for policy going forward. In the months and years post-Covid, almost every bank meeting had a hike fully priced – leading to minimal direction volatility and a consistent march higher in rates. Now, as we appear to be turning a corner with inflation, central bankers are promoting a more nuanced stance – the result of which could be a marked increase in two-way interest volatility.

The Fed came first and, as expected, hiked rates by 25bps taking the upper bound to 5.5%, its highest level in 22 years. In the press conference that followed, Chairman Powell cut an indecisive figure. He claimed it was too early to say whether or not this was the final hike. He also claimed that future hikes would be data dependent, although between the previous meeting (no hikes) and this meeting (25bps hike) headline inflation had fallen markedly. This change in rhetoric amplifies the importance of every data point and Fed speech. Indeed, in the days following the meeting, we saw positive data (a GDP outperformance) result in a 15bps move higher in short term rates, and weak data (labour market data miss) result in a 15bps fall in those rates.

The ECB followed and the story was much the same – they hiked 25bps to 3.75% but lost their air of certainty that had been prevalent in recent meetings. Lagarde again emphasised the role of data in any upcoming moves and went on to really foster uncertainty by saying: "There is the possibility of a hike [next time]. There is the possibility of a pause. It's a decisive maybe." In the days following the meeting, Lagarde doubled down – telling Le Figaro newspaper that, “a pause, whenever it occurs, in September or later, would not necessarily be definitive.”

Lastly, we heard from the Bank of England – out of the three, this was the bank most likely to stick to previous rhetoric and the stickiest inflation issues, however, even here we saw a change in tone. Though the minutes indicated that rates would stay “sufficiently restrictive for sufficiently long” to return inflation to 2%, Bailey presented more balance. He highlighted that we had two-way risks from here and that “there is no presumed path of interest rates.” Rate expectations in the UK fell following the meeting and markets now expect rates to peak almost 0.5% lower than they did in early July. But recent positive data suggesting a more robust property market than expected and growth upgrades from the IMF should allow the BoE to act more strongly if inflation refuses to moderate.

In such environments when the risks of both higher and lower rates are elevated, interest rate caps become very attractive options – allowing hedgers to participate in the downside whilst fully protecting from moves higher. And though the initial outlay is still more significant than years gone past, at-the-money 3y caps in EUR, GBP and USD are all significantly cheaper than they have been over the last year.