Deutsche Bank: Markets May Underestimate Rate Peaks After Central Banks' Coordinated Rate Hikes

Historical experience shows that markets often underestimate the peak of interest rate hikes.

Written by: Li Jia, Wall Street Insights

Deutsche Bank points out that as the central banks of the U.S., Europe, and Japan tighten their policies simultaneously, the market may still be underpricing the final interest rate. With high oil prices, inflation may transmit to core inflation and wages; meanwhile, financial conditions have not tightened in sync, potentially weakening the effects of rate hikes. Deutsche Bank cites the experience from 2022, when the market expected the Federal Reserve to raise rates by about 200 basis points in the first year, but the actual increase exceeded 400 basis points, indicating that the market often underestimates the peak of rate hikes.

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

Deutsche Bank believes that a key risk currently facing the market is that inflationary pressures may last longer than expected, while financial conditions have not deteriorated in sync with policy tightening. In this scenario, central banks may need to keep interest rates at higher levels for a longer time to achieve the desired tightening effect.

Energy prices are an important basis for this judgment. Although oil prices have fallen 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 points out that the impact of energy shocks extends beyond oil prices; if price pressures further transmit to core inflation and wage expectations, the pace of inflation decline may be slower than the market currently expects.

Meanwhile, 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 tightened significantly due to rising policy rates. Deutsche Bank believes this may weaken the demand-suppressing effect of rate hikes, putting pressure on central banks to further tighten policies.

Historical Experience Shows That Markets Often Underestimate Rate Peaks

Allen specifically reminds that the market underestimating the extent of tightening is not a new occurrence. Deutsche Bank cites the experience from 2022, when investors initially expected the Federal Reserve to raise rates by about 200 basis points in the first year, but the actual increase exceeded 400 basis points. In other words, the market often fails to fully account for subsequent policy adjustments at the beginning of a tightening cycle.

This experience is particularly noteworthy in the current environment. Compared to 2022, when inflation surged above 8% before significant policy tightening, major central banks are now responding to price pressures much more quickly. Allen believes that after experiencing the last round of inflation shocks, central banks may be more inclined to prevent inflation from spiraling out of control again, thus potentially bringing forward their policy response functions.

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

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