Have markets celebrated the interest rate peak too early?

The US economy is showing signs of immunity to policy tightening with sticky inflation

A trader at the New York Stock Exchange. US inflation in August came in higher than expected, rising 3.7 per cent on a 12-month basis. EPA

Investors have been waiting all year for central banks to declare victory over inflation, at which point markets could throw a party in anticipation that interest rates would peak and, with luck, fall as fast as they rose. Now, we’re almost there.

The European Central Bank raised eurozone interest rates to a record 4 per cent last Thursday but signalled that its 10th increase in 14 months could be the last rise in this cycle.

European stocks enjoyed their strongest day in six months, closing 1.5 per cent higher, while the FTSE 100 jumped 2 per cent, and the rally continued on Friday. Better news about the Chinese economy also helped.

Markets expect the Bank of England to deliver one more 0.25 percentage point rise this week, to 5.5 per cent, while the Fed may hold rates at 5.5 per cent this month (possibly with one more increase by year end).

So, are markets about to enjoy the long-awaited bonanza?

Nobody should underestimate how fast interest rates have soared. In February 2022, the Fed funds rate stood at just 0.08 per cent. If it hikes once more to 5.75 per cent, that works out as an increase of 7,087.5 per cent.

Higher interest rates are designed to destroy inflation by driving up borrowing costs, which makes businesses and consumers feel poorer and less inclined to spend, cooling activity.

It’s a blunt and brutal instrument, though. Profits fall. Businesses close. Jobs go. People lose their homes. Share and property prices drop.

The alternative is to let inflation run out of control, which is worse.

On the plus side, higher interest rates are also supposed to encourage savers to tuck money away rather than go on a spree, as they get higher returns on their deposits.

In 2022, the policy shift did its work as global markets crashed and frothy assets like Bitcoin took a beating.

Monetary policy takes around 18 months to feed through to the real economy but now it appears to have arrived, says Samy Chaar, chief economist at Lombard Odier.

He thinks the ECB’s job is done. “Given abundant evidence that monetary policy transmission is working, with both inflation and growth momentum fading, the case for tightening will likely weaken in the months ahead,” Mr Chaar says.

The UK economy is also showing signs of cooling, says Vijay Valecha, chief investment officer at Century Financial.

“Gross domestic product fell 0.5 per cent in July, while industrial production also declined more than expected. September’s hike could be the last,” he adds.

It’s a different story across the Atlantic, where Wall Street has recovered almost all of last year's losses, driven by the artificial intelligence-fuelled tech stock revival.

The US economy is showing surprising “resilience” to higher interest rates, with the labour market and producer prices both proving stronger than expected, says Ryan Brandham, head of global capital markets for North America at Validus Risk Management.

“Further Fed action may be required,” he says.

Consumer prices jumped 0.6 per cent in August, the biggest monthly gain of 2023, largely due to higher fuel prices. Inflation rose 3.7 per cent over the year, notably higher than July’s 3.2 per cent.

While European and UK stock markets rebounded sharply last week, US markets saw more muted gains, says Chris Beauchamp, chief market analyst at online trading platform IG.

He calls resurgent inflation a “wild card” that could force more Fed rate hikes.

Watch: Bank of England raises interest rate to 15-year high

This may be partly down to President Joe Biden’s Inflation Reduction Act, which is pumping $1 trillion into clean energy, heating up the economy at the same time as the Fed tries to cool things down.

So, we’re not out of the woods yet.

There’s another worry holding markets back. Stagflation.

The economy won’t suddenly spring into life simply because interest rates have peaked. They are still dramatically higher than before.

Growth could be hard to come by until central banks start cutting rates and markets now fear that may not happen until the second half of 2024.

Mr Chaar warns that “growth will likely remain subdued and almost in stagflation territory”, and he’s not the only one to use the S-word.

William Marsters, financial markets expert at Saxo Bank, anticipates “light stagflation”, which he says normally leads to poor equity returns.

“Defensive sectors often outperform in this environment, so investors might consider consumer staples, energy, health care and utilities,” he says.

Richard Flax, chief investment officer at wealth manager Moneyfarm, notes that the ECB has upgraded inflation predictions for 2024 to 3.2 per cent.

Given abundant evidence that monetary policy transmission is working, the case for tightening will likely weaken in the months ahead

Samy Chaar,
chief economist, Lombard Odier

“This stagflationary picture, with weakening growth and sticky inflation, is a challenging scenario,” he says.

While the ECB reckons inflation will average 2.1 per cent in 2025, we may still have to “stomach-deteriorating economic data for the sake of curbing inflation”, Mr Flax adds.

Nobody was ever going to bang a gong and announce the start of the next full market by claiming inflation was dead.

Life isn’t like that. Investing certainly isn’t. Investors have raced ahead of reality. They do that.

Bond markets are “jittery” as they wait to see what happens next, with two-year US Treasury yields climbing past 5 per cent, says Jason Hollands, managing director at wealth manager Evelyn Partners.

However, we may enjoy a boost from a surprising quarter.

“The deterioration in the Chinese economy could place additional downward pressure on global inflation. The weak yuan, alongside falling factory gate prices, will make Chinese manufactured goods very cheap in global markets,” Mr Hollands adds.

He thinks the Fed will hold off from hiking rates this month, but says hopes that rate cuts would swiftly follow have faded.

“Economic resilience has changed that. Rates may soon peak, but they look set to remain higher for longer,” he says.

The war on inflation isn’t won yet, so investors may have to be patient just a little while longer. Unfortunately, patience isn't their strong point.