It has been highly anticipated that the Federal Reserve may pause interest rates this month after 10 consecutive interest rate hikes since March 2022. When Fed Chair Jerome Powell delivered the last conference in May, the message sounded optimistic, as if he were finally reaching “the end of the tunnel” with interest rates. Investors were finally hoping that this month, the Federal Reserve will put a halt on hiking interest rates, which could finally loosen up a little bit the credit market, and boost demand again. Now, this optimistic sentiment is under threat.
Indeed, central banks around the world start to hike interest rates again. The Bank of Canada defied expectations by restarting its interest rate tightening campaign, saying the economy is running too hot. The Canadian central bank unexpectedly hiked its interest rates to 4.75% on inflation, housing, and other economic indicators. This hike is the highest since 2001. In fact, this rate hike ends its four-month pause on interest rates.
The Reserve Bank of Australia also defied market expectations by raising its benchmark rate by 25 basis points to 4.1%. Philip Lowe, the incumbent Governor of the Australian central bank stated: “If inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment.” The Australian central bank’s boss added that there may be further hikes required to bring down the nation’s inflation rate.
The European Central Bank (ECB), chaired by French central banker and economist, Christine Lagarde, announced on Monday that price pressures were strong, and made it clear that the bank will raise interest rates high enough to bring down inflation and keep them there “for as long as necessary.” Lagarde’s remarks reinforced her earlier statements indicating the ECB was not done raising rates even after inflation fell by almost a full percentage point in May, to 6.1%.
The pattern is crystal-clear. Central banks in advanced economies are further tightening their credit markets. What makes banks unique is their susceptibility to the domino effect. One action performed by a major bank will necessarily influence other banks to do the same and follow the trend. Now that central banks around the world are hiking their interest rates again, it is likely that the U.S. Federal Reserve does the same. If the Federal Reserve decides to hike once more interest rates, how this would affect financial markets and the economy overall?
First, it is important to understand that although inflation is slowing down, which is a good sign, there is no guarantee that the Fed will pause. Powell claimed that the Fed’s decision to pause interest rates will depend on their assessment of economic data. If some economic indicators still look strong while inflation remains high, the Federal Reserve may decide to hike rates, and further tighten the U.S. credit market.
The bond market, which is the epicenter of the credit market, will be severely affected by another rate hike, especially for bondholders who hold long-term bonds. Indeed, when interest rates rise, newly issued bonds offer higher yields, making existing bonds with lower yields less attractive. As a result, the prices of existing bonds tend to decline, which negatively affects bondholders. Moreover, high-interest rates may prompt central banks to tighten monetary policy, which can further increase bond yields and lead to a sell-off in bonds.
The stock market will also be affected by this new potential hike. Firstly, higher borrowing costs can reduce the profitability of companies that rely on debt financing, potentially lowering their stock prices. Secondly, as interest rates rise, fixed-income investments such as bonds become relatively more attractive compared to stocks, leading investors to shift their allocations away from equities. This shift in investor sentiment can put downward pressure on stock prices.
Further tightening of the credit market will affect savings and consumption. When interest rates are high, the returns on savings accounts, certificates of deposit, and other fixed-income investments become more attractive. As a result, people may allocate more of their income towards saving and reduce their spending, which can impact consumer spending patterns and potentially affect industries that rely heavily on consumer demand.
In a few days, we will find out what Jerome Powell and his board decide to do. And we shall be prepared for all outcomes.