2023 followed the core theme of 2022 with a key focus on inflation and interest rates. At the beginning of 2023, inflation was a huge concern, due to its high level. In the US, inflation was at 6.5% and already declined substantially from its peak in June 2022 at 9.1%. This trend continued in 2023 until it reached its bottom in June 2023 at 3%. Since then, US inflation remained steady between 3% and 4%. The EU and the UK saw a very similar development of inflation throughout 2022. Their respective inflation started at around 5.5% in January 2022 and rose to 10.5% by the end of 2022. As soon as 2023 started, inflation in the EU started to decline and eventually declined to as low as 3.1% in November 2023. Despite this promising development, inflation began to increase again to 3.4% in December 2023. While the UK’s inflation development was almost equivalent to the EU’s in 2022, this changed in 2023. Inflation in the UK remained above 10% until April 2023, at which point inflation was at 10% or higher for almost an entire year. Nonetheless, UK inflation also came down later in 2023 and reached the 4% mark at the end of December 2023. Based on the overall relatively similar development of inflation around the world, it is likely that inflation will stay at elevated levels in the short term. Another key reason for relatively stale inflation is that central banks stopped hiking their interest rate for a while now in 2023. Figure 1 summarizes the development of inflation in the US, EU, and the UK.
With the soaring inflation in 2021 and afterward, central banks had to react. Financial markets enjoyed rates close to zero, if not negative, for a long time. As a response, central banks started raising their interest rates. The Bank of England was the first to raise its interest rates in December 2021. The Fed followed in March 2022 and hiked its rate in every meeting and by a higher amount on average than the BoE or the ECB. The BoE did so too, but did smaller hikes on average. The ECB followed in June 2022, but they did not hike at every meeting. At the start of 2023, the interest rate in the US was already at 4.25% compared to 3.5% in the UK and 2.5% in the EU. Consequentially, the ECB hiked more in 2023 but did not reach the same heights as in the US or UK, which are currently at 5.25%, while the ECB’s interest rate remains at 4.5%. With interest rates now higher than inflation rates in each of those economies, most market participants expect interest rate cuts in 2024, especially due to an elevated possibility of a recession ahead.
Inflation and interest rates have been present topics. Inflation rates have continuously decreased throughout 2023 across most economies. While this development was promising, it was necessary as inflation rates went as high as almost 12% towards the end of 2022. In the US, inflation has decreased to 3%-4% in the past few months with no particular direction since then. For 2024, it is widely expected that inflation will decrease further, albeit to a limited degree. Most market participants expect inflation to be around 2.3% by the end of 2024. Others see inflation to drop to as low as 1.6%. Assuming no further geopolitical crises and no further escalation of existing crises, inflation is unlikely to rise further than 3.5% by the end of 2024. Figure 1 shows the development of inflation rates in the US, UK, and the EU from January 2022 to the end of 2024. The general sentiment that inflation rates should fall is intuitive given the high interest rates at this time. In the EU, the development has mostly mimicked the US, but with a delay of a couple of months, due to a more restrictive central bank policy when Covid-19 emerged. Inflation in the EU has also reached a point, where inflation is no longer declining at levels slightly below 4% after being at 10% at the beginning of the year. For 2024, inflation is also expected to further fall, but not to the same degree as in the US. Expectations for inflation in the EU range from 2.6% to 4.5% with the most likely level around 3.4%. The situation in the UK also drastically improved towards the end of the year. UK’s inflation fell to 4% after lingering around the 10% mark for almost an entire year. Inflation expectations for the UK are mostly equivalent to the EU’s expectations, but its projections are more volatile based on the country’s state over the past few years.
Bonds have experienced substantial volatility since Covid-19. Back in March 2020, the 30-year US treasury yields fell below 1% for the first time in its history. With the high interventions from the central banks, bond yields have risen steadily, albeit mostly at the lower end. However, the longer end also began to increase and has passed the 5% mark for the first time since 2007, as shown in Figure 1. Nonetheless, this still has not shifted the yield curve back to a normal state, as the 3-month treasury bill is still yielding more at 5.63%. This development also caused the longest and steepest bear market in the bond ecosystem. Measured by the Bloomberg US Aggregate Bond Index, the bear market is now in its 38th month and has resulted in losses exceeding 17% in this time period. In conjunction with rising interest rates, mortgage rates also skyrocketed. 30-year fixed mortgage rates increased from 2.65% in 2020 to more than 7% currently, as shown in Figure 2. The last time, mortgage rates were at such levels was during the dot-com bubble. This has led to a substantial impact on the real estate market. With housing becoming that expensive, many people can no longer afford houses. Consequentially, in the US, mortgage applications have fallen to the lowest levels since 1995. Similarly, construction of apartment buildings also collapsed by more than 40%, which corresponds to the steepest fall since 2010. While financing costs are a significant contributor to this decline, it is also negatively affected by a relatively high vacancy rate and a decline in rent level, due to excess supply.
The cryptocurrency markets have been relatively quiet this year. Aside from the surge at the beginning of the year, cryptocurrencies have remained relatively flat since then. The total market capitalization of the industry started slightly below $1tn at the beginning of 2023 and has remained at around $1.2tn since March 2023. The relatively low volatility of the industry also signals a certain level of cautiousness of investors, as the market environment is not great for the industry. In particular recession concerns are holding the industry back, as cryptocurrencies are notorious for sharp declines. Options data on cryptocurrencies also supports a more defensive notion of investors, as implied volatility is close to a record low. The lower degree of risk appetite is also visible in the Bitcoin (BTC) and Ethereum (ETH) dominance. This measure quantifies the total market capital of BTC and ETH respective to the total cryptocurrency market capitalization. Their dominance has been on the rise since Q3 2022 and shows fewer investments in riskier and emerging projects. Similarly, during these times stablecoin gained more importance in the space due to their stability compared to other coins. Figure 1 shows the total market capitalization of cryptocurrencies and the dominance of BTC, ETH, and USDT. Historically, these times are the most important ones for the space, as it drives innovation. With no frenzy, emerging companies are not in a rush to cash out which allows them more time to develop their projects.