Deutsche Bank: After the three major central banks raise interest rates simultaneously, the market may once again underestimate the terminal rate.

Historical experience shows that the market often underestimates the endpoint of interest rate hikes.

Written by: Li Jia, Wall Street Journal

Deutsche Bank pointed out that as the central banks of the US, Europe, and Japan tighten simultaneously, the market's pricing of the final interest rate may still be insufficient. With high oil prices, inflation may transmit to core inflation and wages; meanwhile, if financial conditions do not tighten in sync, it may weaken the effectiveness of interest rate hikes. Deutsche Bank cited the experience from 2022, noting that the market then expected the Federal Reserve to raise rates by about 200 basis points in the first year, but in the end, it exceeded 400 basis points, indicating that the market often underestimates the endpoint of interest rate hikes.

The Federal Reserve, European Central Bank, and Bank of Japan have all raised rates in the past two weeks, marking the beginning of a synchronized tightening phase in global monetary policy. Deutsche Bank macro strategist Henry Allen warned on Monday that although the market has factored in further rate hikes, the pricing for the eventual rate level in this tightening cycle may still be too low.

Deutsche Bank believes that a key risk currently faced by the market is that inflation pressures may last longer than expected, while financial conditions have not deteriorated in sync with policy tightening. In this scenario, central banks will need to maintain higher interest rates for a longer duration to achieve the desired tightening effect.

Energy prices are an important basis for this judgment. Despite oil prices falling for four consecutive trading days recently, Brent crude still hovers around $96 per barrel, and the overall rise in commodities has not been fully reflected in inflation data and market surveys. Deutsche Bank pointed out that the impact of energy shocks goes beyond oil prices themselves; if pricing pressure further transmits to core inflation and wage expectations, the speed of inflation decline may be slower than the market currently expects.

At the same time, asset market performance indicates that financial conditions remain relatively loose. The S&P 500 index is close to historical highs, credit spreads remain narrow, and the corporate financing environment has not significantly tightened due to the rise in policy interest rates. Deutsche Bank believes that this may weaken the dampening effect of interest rate hikes on demand, putting pressure on central banks to adopt further tightening policies.

Historical experience shows that the market often underestimates the endpoint of interest rate hikes

Allen specifically reminded that the market underestimating the degree of tightening is not a new occurrence. Deutsche Bank cited the experience from 2022, when investors initially expected the Federal Reserve to raise rates by about 200 basis points in its first year, but the actual increase ultimately exceeded 400 basis points. In other words, the market often struggles to fully account for subsequent policy adjustments in the early stages of a tightening cycle.

This experience is particularly noteworthy in the current environment. Compared to the significant policy tightening that followed after inflation broke 8% in 2022, major central banks today are reacting to price pressures much more swiftly. Allen believes that after experiencing the last round of inflation shock, central banks may be more inclined to prevent inflation from getting out of control again, thus making the policy response function potentially even more proactive.

However, higher interest rates do not necessarily mean that the economy or the stock market will weaken. Allen pointed out that in 1999, while the Federal Reserve raised rates and bond yields increased, the S&P 500 index still rose by nearly 20% for the entire year. Therefore, Deutsche Bank's focus is not on whether interest rate hikes themselves will end growth, but rather on whether the market has left enough space for further upward movement in the interest rate path.

If high oil prices persist, the second-round effects of inflation gradually manifest, and loose financial conditions continue to weaken the effects of rate hikes, then the market's earlier bets on rate cuts may need to be adjusted. At that point, bond yields, the dollar, and risk asset valuations may face new pricing pressures.