End of cycle looks in sight for the ECB and the Fed

Jun 23, 2023

While there could still be surprises ahead, with persistent inflation pushing central banks to tighten further than expected, the most likely scenario is that an end to rate rises is now close at hand. (ddp)

But the ECB dropped explicit guidance that rates would need to rise further, signaling instead that further tightening would hinge on whether economic data suggested this was necessary. This leaves the door open to another increase at the ECB’s next policy meeting in September or a pause, perhaps with hikes resuming at a later date if inflation proves more persistent than expected.

In addition, while the Bank of Japan on Friday gave indication that it is backing away from ultra-easy monetary policy (see below), the Federal Reserve also indicated this week that the end of its hiking cycle was probably in sight—having raised rates by 25 basis points at its policy meeting. On balance, we believe there is a greater probability that the ECB will need to raise rates one notch higher, while the Fed is more likely to have finished.

But the ECB and Fed meetings underlined that both central banks are now close to—or have already reached—the peak in rates. Against this backdrop, we recommend that investors:

Manage liquidity as rates peak. Many investors have held more cash than usual in anticipation of higher interest rates. But policy rates are now approaching a peak. Reinvestment risk for investors holding excess cash or fixed deposits will likely rise. We recommend that investors re-evaluate their cash holdings, ensure they are sufficiently invested and diversified for the long term, and act soon to lock in attractive yields before markets start to price lower rates in the future.

Lock in quality bond yields. Yields have risen in recent months as the US economy has proved more resilient than expected. We think this provides a good opportunity for investors to put their excess cash to work by locking in attractive yields as the Fed nears the end of its rate-hiking cycle and before markets turn their attention to rate cuts. The more defensive, higher-quality segments of fixed income look most appealing to us, given the all-in yields on offer and the potential for capital appreciation as investors shift their focus from inflation risks to growth risks. We expect high grade (government), investment grade, and sustainable debt to deliver good returns over the balance of the year, and we prefer five- to 10-year maturities.

Seek yield generation for equities. Quality dividend-paying stocks can be a good source of income and can enhance potential equity returns at a time when the risk-reward outlook for broad indexes appears muted over a tactical horizon. The MSCI World High Dividend Yield index and its sustainable equivalent are offering a yield of around 3.85%, close to the 3.95% currently offered by the 10-year US Treasury. Quality dividend equities tend to be found in more defensive parts of the market, and history suggests dividend payments should prove relatively stable even in the event of an economic downturn. Companies in this category also often have strong pricing power, enabling them to protect margins in periods of high inflation. By region, we think this style has the most potential in Switzerland and in Asia.

So, while there could still be surprises ahead, with persistent inflation pushing central banks to tighten further than expected, the most likely scenario is that an end to rate rises is now close at hand. Investors should position accordingly by locking in durable income streams.

Main contributors - Solita Marcelli, Mark Haefele, Dean Turner, Thomas Flury, Christopher Swann, Vincent Heaney

Original report - End of cycle looks in sight for ECB and Fed, 28 July 2023.