Calibrating the final rate adjustment

This is an excerpt from Santander’s Market Outlook for Q2. For more information on how the markets are resetting, read the full report here.

Monetary policy pause is near

We believe that we are reaching the final phase of rate increases, in which monetary policy decisions need to be finely calibrated in order to reach price and financial stability.

We expect that central banks will press the pause button soon on one of the fastest and steepest rate hike cycles in recent history. Central banks face a significant challenge as they manage the confluence of three factors: persistent inflation, liquidity tensions in the financial system, and the lagged effects of rate hikes in the economy.

Economic growth outlook

Economic activity has been stronger than expected in the first quarter of the year in both the U.S. and Europe. Robust job creation has continued to provide support for private consumption. However, there are signs of weakness in leading indicators, and we expect a significant deterioration of credit conditions in the coming quarters. The present economic backdrop, together with asset valuation, call for caution in risk assets.

Inflation persists

After one of the most dramatic monetary tightening processes in history, we are approaching the time for a pause in interest rate hikes. Central banks are expected to enter a calibration phase of monetary policy that is highly complex due to persistently high core inflation. It is our belief that peak headline inflation is behind us in the U.S. and the Eurozone, but services and food inflation have yet to peak. In the U.S., the labor market is still robust and the high number of unfilled jobs keeps upward pressure on services inflation. Recent bouts of instability in the financial system add further complexity to the central banks' roadmap.

Fixed income finally offers "income"

Our growth and inflation projections envision an environment that favors an overweight in core fixed income over assets that are more sensitive to the economic cycle, such as high-yield bonds and equities. This reinforces the appeal of bonds after investors were starved for yield for years.

No monetary policy pivot without slowdown

Market consensus expected economic weakness in the first few months of 2023, but the vast majority of incoming economic data have been surprisingly resilient. The reopening of the Chinese economy, the absence of energy supply problems in Europe, and the strength of consumer spending in the United States have allowed central banks to maintain the pace of rate hikes. We expect a turnaround in the coming months as household consumption could lose steam and the effects of credit tightening could take a toll on investment decisions. We believe that the pivot on interest rate changes will be announced only when services inflation levels out and signs of weakening economic growth become evident.

For more details on how the global markets and the United States are responding to these shifts, read the full Q2 2023 Global Market Outlook.

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