Following interest rate increases by the Federal Reserve, the European Central Bank, and the Bank of Japan over the past two weeks, global monetary policy has entered a phase of synchronized tightening. Deutsche Bank macro strategist Henry Allen cautioned on Monday that although markets have already priced in further rate moves, the pricing for the ultimate level of rates in this tightening cycle may still be too low.

The bank believes a key risk currently facing markets is that inflationary pressures could prove more persistent than anticipated, while financial conditions have not deteriorated in tandem with policy tightening. In such a scenario, central banks would need to maintain rates at higher levels for a longer duration to achieve the desired tightening effect.

Energy prices serve as a crucial basis for this assessment. Despite oil prices falling for four consecutive sessions recently, Brent crude remains near $96 per barrel, and the broader rally in commodities has yet to be fully reflected in inflation data and market surveys. Deutsche Bank notes that the impact of the energy shock extends beyond oil prices alone; if price pressures further transmit into core inflation and wage expectations, the pace of disinflation could be slower than markets currently anticipate.

Meanwhile, asset market performance indicates that financial conditions remain relatively accommodative. The S&P 500 is near record highs, credit spreads remain narrow, and corporate financing conditions have not tightened significantly as a result of higher policy rates. Deutsche Bank suggests this could weaken the dampening effect of rate hikes on demand, putting further pressure on central banks to tighten policy.

Historical precedent suggests markets often underestimate the peak rate

Allen specifically highlighted that markets underpricing the scale of tightening is not unprecedented. Deutsche Bank cites the experience of 2022, when investors initially expected the Fed to hike by around 200 basis points in its first year, but the actual cumulative increase exceeded 400 basis points. In other words, markets tend to struggle in fully pricing in subsequent policy adjustments during the early stages of a tightening cycle.

This historical lesson is particularly relevant in the current environment. Compared to 2022, when policy was tightened aggressively only after inflation had surged above 8%, major central banks today have responded much more quickly to price pressures. Allen believes that after experiencing the previous inflation shock, central banks may be more inclined to prevent inflation from spiraling out of control again, potentially resulting in a more front-loaded policy reaction function.

However, higher rates do not necessarily imply a weaker economy or stock market. Allen points out that during the Fed's tightening cycle in 1999, even as bond yields rose, the S&P 500 still gained nearly 20% for the year. Therefore, Deutsche Bank's core concern is not whether rate hikes themselves will end growth, but whether markets have left sufficient room for further upward movement in the rate path.

If oil prices remain elevated, second-round effects of inflation gradually emerge, and loose financial conditions continue to blunt the impact of rate hikes, then markets' previous bets on rate cuts may need to be reassessed. In that case, bond yields, the US dollar, and risk asset valuations could all face renewed pricing pressures.