Positive Peak Real Rates Show Easier Financial Conditions On Way

Authored by Simon White, Bloomberg macro strategist,

The peak in real short-term rates is now positive across the US, Europe and UK.

This allows central banks to soften their hawkish stances and points to a further forthcoming easing in global financial conditions. On its own that’s supportive for assets, but there are several risks to bear in mind.

The US got there first, with the peak in the real SOFR rate (based on the SOFR futures curve) going positive earlier this year. Europe and the UK lagged, but they too now have positive peak real rates.

If that can be considered some sort of “mission accomplished” for central banks (any celebrations are likely to be premature – more below), then they are beginning to show it by more explicitly countenancing the likelihood rates are at their terminal level, and therefore the market can – as is its wont – proceed with pricing in what it thinks will happen next, i.e. rate cuts next year.

Federal Reserve Board Member Christopher Waller’s comments on Tuesday flick in that direction, stating that a continued slowing in inflation of at least several months’ duration may open the door to rate cuts, while the ECB’s Stournaras said today that the first cut in Europe could come in the middle of 2024.

Financial conditions have eased recently with lower yields, higher stocks, tighter credit spreads and falling asset volatility.

But they are set to ease further as central banks dial back on higher for longer, which will implicitly blunt the effectiveness of their policy rate.

The chart below shows the Global Financial Tightness Index (GFTI; black line in chart), essentially a diffusion of global central-bank rate hikes.

It has started to rise as banks step away from hiking and some start to cut, easing financial conditions.

The Advanced Global Financial Tightness Index (AGFTI; brown line in chart) uses central-bank rate expectations to lead the GFTI by about six months. As we can see, softening of central-bank hawkish rhetoric is allowing the AGFTI to rise, pointing to the GFTI continuing to rise also, i.e. financial conditions should keep easing.

On its own, that’s supportive for risk assets, already enjoying tailwinds from buoyant liquidity conditions.

How long this can continue is another matter.

Some of the main risks to consider are:

• the depletion in the Fed’s reverse repo (RRP) facility (a next-year problem);

• the US Treasury skewing issuance away from bills again (watch the next quarterly refunding announcement in late January);

• a US recession (looking less likely over the next six months);

• and a re-acceleration in inflation which next year would put central banks right back where at the moment it is clear they don’t expect to be.