Is the Hurting Over?

Is the Hurting Over?

The prospect of the U.S. Federal Reserve being on hold could be a positive for many markets, particularly in those countries where central banks were early to tighten.

2024 may be the year that central banks generally stop being a headwind for government bond performance, but the question of whether they can morph into a tailwind is largely a regional and country-specific one.

Global growth in 2024 should continue to be impacted negatively by the lagged effects of all the tightening done so far. These after-effects are being felt across the world to varying degrees.

Those countries that took a proactive approach to tackling inflation and aggressively raised rates early on are now feeling more of the impact of that tightening, with their economies showing signs of a slowdown. Parts of Latin America and Eastern Europe fall into this category. On a more positive note, inflation in those regions declined enough in many cases to support a shift to easier monetary policy. Yet while markets gradually bought into the rate cut enthusiasm, it was quickly replaced by skepticism as U.S. growth continued to surprise many with its resiliency earlier this year, leaving the black cloud of further tightening by the U.S. Federal Reserve (Fed) still on the horizon.

More recently, however, America’s economy seems to be finally showing signs of slowing, and with that comes a higher likelihood the Fed stops hiking interest rates. We have been here before, though, and markets are once again getting excited and bringing forward the timing of rate cuts. Should U.S. growth continue to soften, the prospect of rate cuts starting in 2024 is valid, but it’s shaping up to be a second-half story at best. Inflation, though falling, still needs time to prove itself more broadly benign and to reach a more comfortable level in absolute terms. It’s hard to envision the Fed cutting rates materially when inflation is still above target, so markets should not ignore the possibility of few – or even no – rate cuts in 2024.

The Bank of Canada might be in a better position to gradually ease policy rates in 2024 because the Canadian economy has seen virtually no real growth for much of 2023. Additionally, a large portion of higher-cost mortgage renewals will be coming due over the next year, which will put even more pressure on an already stretched consumer.   

The back-and-forth debate between easing policy rates or keeping them restrictive is a probable scenario for the first half of the year. It seems probable that the Fed will throw cold water on the market’s desire for an early ease. Still, the prospect of the Fed on hold could be a positive for many markets, particularly in those countries where central banks were early to tighten. Countries such as Mexico and Brazil have very high real rates and may be able to gently ease policy rates if the Fed is indeed done.

Western Europe is experiencing slower growth already, which has put the European Central Bank (ECB) in a holding pattern. Much of this slower growth profile can be attributed to a lacklustre Chinese economy. The Asian region has been generally running counter to its European and American counterparts, in that inflation has not been as much of an issue. As a result, central banks in the region never implemented the same degree of policy tightening. 

The Bank of Japan (BOJ) is an outlier, having made only small adjustments to its yield curve control strategy despite elevated inflation. In 2024, a meaningful change to its policy stance is likely, however, with an effective end to yield curve control and a positive policy rate for the first time since 2015. That said, the BOJ will probably move more slowly and gradually than most expect, with more minor implications for global rates markets.

Irrespective of what happens in 2024, government bond yields at close to 20-year highs are giving investors a head start. Running yields are providing a competitive return, with the added benefit of a potential risk offset should growth really deteriorate. However, volatility may remain elevated on the ebb and flow of the growth-versus-inflation narrative, exacerbated by the higher cost of deficit funding that virtually all countries face. This lack of fiscal space is another reason why the growth picture overall could be more muted than markets might hope.