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Current and ex-FED governors have been vocal over the past week that market participants should expect a ‘fast and furious’ FED policy normalisation path. The initial March 16 hike of 25bp will be followed by a series of 50bp hikes. The market prices around a 90% probability for 50bp hikes on May 4 and June 15 FOMC meetings. In order to preserve their credibility, expect a similar stance from the July 27 and September 21 FED sessions. That would bring the US monetary policy rate at 2.25%-2.50% by the very end of the summer of 2022. What happens afterwards will depend on the pace of the inflation decline. The complexity of inflation modelling is high. Energy and supply constraints seem to exhibit persistency. Second round wage inflation effects are highest in the US compared to other OECD countries. The question that requires an answer is when will tightening financial conditions for real economic agents have a negative impact on investment for corporates versus spending for the consumer.
As long as the labour market remains buoyant, initiating a real change in corporate and consumer sentiment, one that depresses inflation, will take monetary (and fiscal) courage. The textbook or historical comparisons are of little use for what’s ahead. However, we do have some rules of thumb that might be helpful as we experience a rare moment in US monetary policy over the next 12 months. Because, indeed, if inflation has not backed off by late September, expect the steady 50bp increment to be applied over the November 2 and December 15 FED meetings. That would finish off 2022 with a FED policy rate at 3.25%-3.50%.
Under the above scenario, expect the US curve to fully invert and keep that inversion intact. Within the market, we have witnessed a brief 2-year vs 10-year US rate inversion between April 1 and April 4. Renewed weakness across the main US equity indices since then has pushed investors towards the safety of short-term US bonds. That has caused a temporary steepening. However, the FED is on a mission. The White House is on a mission as well and wants the ‘inflation debate’ that rages in the streets to die down urgently. The alignment of interest between the FED and the White House suits them both. The FED is fully aware that in order to anchor long-term rates, it requires them to go all-in on policy rates. Because, indeed, long-term rates are setting the level of long-term mortgage rates. The 30-year fixed mortgage rate has climbed towards 5.25%. That is 25bp above the 25-year average of about 5.00%. The White House hopes to achieve a status quo or a Democratic House as a result of the midterm elections on November 8.
Investing under such a flat to inverted yield curve over the next 12 months should not be that detrimental. Flat or inverted yield curve conditions will allow bond investors to build attractive carry per unit of duration. The sweet spot will become the 5-year to 7-year point over time as we reach the terminal rate. From that moment onwards, over 2023 and 2024, the market might prepare for a more accommodative FED and a bull steepening episode. That is still an eternity away from today. In the meantime, bond investors, who have to stomach the worst bear market impact since 1994 and, before that, early 1980, must focus on the yield on offer. That yield will allow one to estimate and pencil in recovery times. Remember, bond investors should prefer a sharp spike in yields than a protracted one. The latter opens the door to ill-timed, bad decision making in bond investing. Participants start to focus on the short-term that sees no tangible recovery. Lack of meaningful progress make them to bail-out the very moment value returns to bond markets. Indeed, the current aggressive repricing has given rise to a speedy appearance of attractive long-term yields…across bond sectors, from DM to EM markets. The tricky part is to make a strong selection across sovereign and corporate credit as the FED is on a boom-bust path. Quality is king.
The average period between ‘sticky’ inversion and recession has been about one and a half years. If such sticky inversion would be in place by September, expect US growth to decelerate firmly by early to mid-2024. Accept a long and variable lag between yield curve inversion and the start of a genuine, recession-driven, equity correction. Especially this time around, when fiscal policy instruments might be protecting consumers most exposed to the current high inflationary episode. The FED and the White House will aim for a soft landing. The FED, however, will not buckle if a hard landing is in sight. Indeed, expectations of a FED put, where market pressure changes the FED policy rate path and stance, should not be taken for granted. Fighting inflation successfully is what matters and what counts. Across equity markets, we notice that, in periods before the GFC of 2008, the time between yield curve inversion and when recession hits features positive equity returns between 5% and 10%.
I honestly believe that deriving rules of thumb out of market conditions that occurred during QE times might be a waste of time and energy. The signal strength has been weakened through various QE programmes since 2009.
So, equity markets behave very well (1-year return expectations above 10%) under bear steepening yield curve moments, as the steepening is induced by strong economic growth expectations. Equity markets also behave correctly (1-year return expectations between 4% and 6%) when yield curve bear flatten or bull flatten. The conditions that equity markets should dread is the bull steepening of the yield curve. As mentioned earlier, we should not expect this anytime soon.
The purpose of this note was not to provide you with point estimates or thresholds that should trigger action. The purpose was to inform you on the exceptional path ahead. Exceptional, as it will feature a 1994 style US FED tightening cycle nearing 300bp well within a year’s time. However, this time around, let’s hope and expect the long end of the yield curve to remain stable as the FED kills rising inflation expectations. Economic conditions today are still well supported, and the upcoming monetary tightening will only impact with a long lag. During that time, equity markets can uphold an acceptable range around current valuations.
Enjoy the movie.