On December 15 last year, the US Federal Reserve expected its near-zero cash rate (known as the Federal funds rate) to rise only modestly to 0.9 per cent by the end of 2022 and to 1.6 per cent by 2023. Financial markets had a similar view, pricing in just a 1 percentage point Fed funds rate 12 months ahead.
This week, the Fed’s chairman, Jay Powell, delivered yet another hawkish shock to investors. The Fed raised rates by 0.75 percentage points, as widely expected, but accompanied this with big upside surprises to its projections for where it thinks its cash rate will land at the end of 2022, 2023 and 2024. This has serious ramifications for global asset pricing.
In June, the Fed forecast that it would probably boost the Fed funds rate to 3.375 per cent by December. On Wednesday, markets were fingering a higher 4.23 per cent rate. The Fed comfortably bested this estimate, lifting the central expectation for the Fed funds rate in December to 4.4 per cent via its statement of economic projections, also known as the “dot plots”.
The June dot plots had the Fed hitting a peak cash rate of 3.75 per cent by the end of 2023. Financial market pricing this week pointed to a 3.97 per cent rate at that juncture. The new dot plots blew this out of the water, forecasting 4.6 per cent.
Finally, markets had been pricing in a materially lower cash rate of about 3.1 per cent for the end of 2024. In June, the Fed was broadly in that ballpark, projecting 3.375 per cent. The latest dot plots racked this much higher to 3.9 per cent, underlining the Fed’s position that it is not likely to provide much in the way of interest rate relief for years to come.
Concurrently, the Fed has slashed its estimate for economic growth this year from 1.7 per cent to nothing and now anticipates a more meaningful increase in the unemployment rate from 3.7 per cent to 4.4 per cent.
“The Fed joins the Bank of England and Riksbank in effectively factoring in a recession as the cost of containing inflation,” says Kieran Davies, our chief macro strategist.
Jackson Hole game-changer
Coming into the Fed meeting this week, we had taken profits on about half of our shorts/hedges in US and European credit. After being short over $8 billion of US and Euro credit since late last year, we had monetised almost all of this position over May and June on the basis we thought risk would rally.
While this came to pass, Powell’s blockbuster Jackson Hole speech in late August was a game-changer. Within about one minute of reading it, we had reinitiated some of our US/Euro credit hedges/shorts. The core message from that speech was that Powell was singularly focused on crushing inflation and inflation expectations, and would not be halted by the threat of a recession.
One new nuance in this context has been the political pressure being placed on central banks to eliminate the global inflation problem, which has opened the door to much more restrictive settings. Rather than populist politicians acting as a handbrake on rate increases, they are in many cases lubricating the wheels of the monetary policy machine.
About 10 seconds after the shockingly high US core inflation print last week, we doubled the size of our credit hedges/shorts, taking profits on these positions just before the Fed’s meeting.
We re-entered these positions again after the Fed’s announcement once we had synthesised the signal from the change in the dot plots, which seemed to be unambiguously bad news for risk and equities more specifically.
Bank deposit rates north of 3 to 4 per cent and high-grade bonds paying 6 to 7 per cent are massively increasing the hurdle rates for all investments. And as much higher long-term interest rates reduce the estimated value of defined benefit pension fund liabilities globally, trustees are inexorably shifting out of the high-risk equities exposures they had previously assumed to try to generate aggressive returns to close the gap between their assets and their unfunded future obligations. One beneficiary is likely to be much lower-risk cash and fixed-income securities that are suddenly offering historically attractive (and liquid) risk-adjusted returns.
Difficulty decoding Fed speak
Curiously, equities initially rallied after the Fed decision and into the first part of Powell’s press conference. This continued a thematic we have noticed since last year where the equities market has struggled to accurately unravel the meaning of key data releases and Fed communications.
One explanation is that the growth in the influence of passive funds and retail investor participation has made the sharemarket noisier and less informationally efficient. Another is that the algorithms and quants that control much of the short-term price action are finding it difficult to decode the import of data surprises and Fed speak.
About 45 minutes after the Fed decision, the S&P 500 had bizarrely rallied more than 1 per cent, which made no sense. Yet as with many prior sessions along these lines, it slumped to a loss of more than two percentage points by the time the market closed. That primary Ponzi proxy, bitcoin, naturally followed suit, trading down into the low $US18,000 territory.
Other global central banks are synchronising alongside the Fed, sharply increasing their cash rates in the knowledge that they will crush demand, materially boost jobless rates and, in time, put downward pressure on wage growth and inflation.
Despite no evidence of a wage breakout in Australia based on either the official wage price index or the RBA’s liaison with businesses, our central bank has been among the most aggressive in the world, imposing 2.25 percentage points of rate increases on borrowers over its past five meetings.
Given the potency of domestic rate changes due to Australia’s unusual preponderance of variable-rate debt, this has triggered the fastest housing correction in modern history.
All of this is bad news for most asset classes, including equities, commercial and residential property [and] infrastructure.
Desperate to avoid any more policy missteps vis-à-vis peers in the face of the federal government’s independent review of its decision-making framework, the risk is the RBA blindly follows the Fed even though governor Philip Lowe has recently been at pains to point out that Australia does not share the same labour cost concerns as the US.
This is somewhat ironic because the RBA has previously argued that emerging wage pressures were one reason it was keen to normalise its cash rate to its neutral level while acknowledging it has no clear understanding of where that neutral cash rate actually lies.
All of this is bad news for most asset classes, including equities, commercial and residential property, infrastructure and the riskier parts of the illiquid loan and high-yield bond market. Investment banks are highlighting a noticeable reduction in high-yield bond issuance in the US and Europe as companies hope they can wait out the turbulence by drawing down on their cash reserves and locking in cheaper interest rates at some more benign point in the future. Bank traders have similarly noticed a dramatic reduction in the secondary trading of high-yield bonds as global funds suffer outflows.
Our central case remains that this interest rate cycle will drive a sharp increase in defaults and stealthy restructurings in the riskier bond and loan markets that were providing non-bank finance to companies that could not access the money via the more conservative banking system.
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