Fixed Income Spotlight: Inflation and Monetary Divergence: Twin Themes in 2022

Inflation and monetary divergence — Twin themes in 2022

Rising inflation in many economies this year has been a game changer for interest-rate expectations in 2022. It has led to growing market divergences among developed central banks and also between emerging and developed markets. At the start of 2021, market expectations for central bank policy rates anticipated a mere 0.25% tightening from the

U.S. Federal Reserve (Fed) by the end of a three-year period. However, over the year, as annual U.S. consumer price inflation accelerated from just 1.4% in December 2020 to reach 6.2% in the latest October release, these benign lower-for-longer views quickly succumbed to reality. Norges Bank (the central bank of Norway) became the first developed market central bank to increase policy rates post-coronavirus on September 24, and the Reserve Bank of New Zealand followed less than a month later.

Mind the gap

The current state of expectations for central bank policy rates in developed markets is shown in the chart below. Rates are seen rising a certain amount everywhere (with the exception of Japan). However, the gap is immediately apparent between two categories of central banks: those expected to quickly raise rates and normalize post-coronavirus monetary policy and those where policy is expected to remain exceptionally easy and rates exceptionally low, even negative. New Zealand is leading the move to normalize rates, but we believe it will be the U.S. Federal Reserve where policy will be most important for domestic and global bond markets and currencies.

Sources: Bloomberg and Wells Fargo Investment Institute. Latest data as of November 19, 2021. These interest rate expectations are derived from the Overnight Index Swaps (OIS) market. An OIS is a fixed to floating interest rate swap where the floating leg is computed using a published overnight index rate, and these swap rates are commonly used (as here) to indicate market expectations of central bank policy rates

The Fed is expected to lift the federal funds rate off zero soon after midyear in 2022, and federal funds futures markets are implying two to three 0.25% rate hikes before the end of the year. By contrast, market participants are unsure if the European Central Bank (ECB) will even move its benchmark deposit rate off the -0.5% lows next year. This is in part because the ECB is seen as more dovish than the Fed and in part because eurozone inflation rates are significantly lower than those in the U.S. The clear implications of these views, already playing out in markets, is that the interest-rate differential between the U.S. and the eurozone should continue to widen, at least until inflation is seen to have peaked, and this should be a powerful support for the dollar.

On a broader level, central bank policy rates have already started to diverge between emerging and developed economies. As the chart below illustrates, emerging market (EM) central banks have been raising rates for well over a year now. This movement gathered pace in 2021, with central banks across Latin America and Eastern Europe, and even the Bank of Korea in Asia, moving to normalize rates. Of the 26 EM central banks we follow, 12 have so far raised rates in 2021.

Sources: International Monetary Fund, Bank for International Settlements, national central banks, Bloomberg, and Wells Fargo Investment Institute. Latest data as of November 19, 2021. The developed markets (DM) series is a weighted average of 11 DM central bank policy rates, using gross domestic product (GDP) at purchasing power parity (PPP) as weights. Purchasing power parity is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries’ currencies.

Emerging market implications

Many EM economies have lower levels of government debt than developed markets, and this factor may be enabling them to be more proactive in raising rates to combat inflation. While higher rates in EM domestic markets may hit local-currency bond returns, and — insofar as they cool the overall economy — also decrease prospects for EM equities, we believe dollar-denominated sovereign credit should continue to hold up well in this environment. While higher rates may not strongly boost EM currencies in the coming year, they may limit their potential depreciation, and weaker EM foreign exchange rates may continue to reflect the strength of the dollar against developed market currencies (notably the euro and yen).

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