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This week’s title combines three themes that can be of help in scenario building, prevent subjectivity in decision-making and improve assessment skills when interpreting market and performance volatility over the next couple of years. The themes relate to past US rate hiking cycles, the possible (high) pace of US policy rate hikes that await us, alongside the question if we need to fear the liquidity drain because of quantitative tightening. In general, market participants are advised to study upcoming policy rate tightening tracks that have been announced but also already applied by major central banks across DM and EM economies.
The FED has not hesitated to assume leadership in setting an example of how a DM central bank should behave in the face of disruptive high inflation. With headline US CPI at 7.00% and core inflation at 5.5%, the US takes the number 1 spot within G7 economies coping with the highest inflation reading. The US Administration expects a firm response from the FED as inflation worries and chatter has reached main street. With an all-important mid-term election for Biden awaiting over Q4 2022, inflation prints must recede over H2 2022. Our focus should remain on the core PCE (Personal Consumption Expenditure) index that made a high at 4.9% last week. The latest December FED SEP (Summary of Economic Projections) put core PCE at 2.7% end of 2022, 2.3% end of 2023 and 2.1% end of 2024. This is important, as the FED will allow a multi-year overshoot versus the 2.00% objective. That will shape their steady rate-hiking pace and not a disruptive one (with 50bp increments) over the next couple of years
During last Wednesday’s FED press conference, Chair Jay Powell announced, almost with pride, that the maximum employment objective was in the pocket. In the eyes of the FED the labour market has nearly fully recovered from the COVID-19 impact with U3 unemployment dropping below 4.00%, job vacancies reaching historic highs alongside a sound wage-growth reading. Tackling the inflation overshoot, predominantly attributed to energy and goods inflation, is the primary task at hand. The market settles for 5 hikes over 2022 and another 2 to 4 over 2023.
Such a drill takes us back to the fast and furious 1994-1995 hiking cycle that took a mere 13 months with 25bp, 50bp and 75bp increments for a total of 300bp of hikes. An overheating US economy posting real growth at +5.9% over Q4 1993 unnerved the FED over inflation fears. The disorderly, erratic path of 6 hikes induced panic into markets. A similar, slightly more moderate and protracted cycle of 2004-2006 mostly with increments of 25bp springs to mind. On aggregate, that episode totalled 13 hikes totalling 425bp. The market busts that ensued following the protracted rate hiking cycles between 1994-2000 and 2004-2006 need no further explanation.
So, even if the cycle ahead of us might have a similar fast pace to 1994, it should be less disorderly adding between 175bp up to 225bp to the current FED funds rate. Less policy rate increases will be required as in parallel the FED’s balance sheet runoff will resume as of this summer. The runoff option was clearly advanced by Chair Powell on Wednesday, January 26. Active selling of Mortgage-Backed Securities (MBS) or US Treasuries is not an option. Chair Powell stressed the importance of maintaining ‘an ample reserve policy strategy’. Expect on average a USD 1 trillion to USD 1.2 trillion a year balance sheet reduction by not reinvesting maturing principal in outstanding T-Bills, US Treasuries and MBS. More importantly expect a continued high intensity of reinvestments in T-Bills, as the FED wants to maintain ample reserves within the banking system to prevent sudden or exceedingly aggressive tightening conditions in money markets. Often, financial market volatility has been caused by clogged money markets and ill-functioning demand-supply conditions across short-term (less than 12 months) funding instruments. The lack of reinvestment at the longer end of yield curves is less of an issue given the relative attractiveness of long-end US rates. The Treasury issuance calendar after bloated US Treasury issuance years of 2020 and 2021, will witness an aggressive drop over 2022. The fiscal drag that pushes the budget deficit from 15%+ over 2021 towards 5% in 2022 provides some technical support.
The big difference between today and 1994 is FED style and FED communication. Back then, the first rate hike in early February 1994 shocked the bond world. I remember it vividly. End of January 1994, 10-year Treasury rates sat at 5.65%. Because of complete lack of forward guidance, 10-year rates rose to a high of 7.90% by November 1994. The cold turkey rate hiking cycle initiated early 1994 led to a drop in housing inflation, a collapse below 50 in ISM manufacturing confidence as well as a stalling unemployment rate. We might expect a similar reaction across above economic variables without the blow-out sequence in US 10-year rates. Effectively, by the end of 1995, 10-year US rates had fallen back to 5.65%. Today, it is mindboggling that 10-year US rates are at the level of March 2021. After having gone through an inflation scare over the past 9 months, taking us from 4.2% headline US CPI over April 2021 all the way up to 7% end of 2021…it feels as if we missed a bond bear market episode. The US Treasury 2021 bond bear that never was.
The above paragraph reveals an interesting read-through looking at the pre-emptive rate hiking cycles that EM central banks engaged in over 2021, early 2022. Indeed, some brutal rate hiking decisions over 2021 across EM central banks inflicted intense harm across EM long rates. Local currency EMD was the main culprit. Early 2022 EMD hard currency comes under stress even when US 30-year rates only rose a modest 20bp since January 1st.
Point in case is the Brazilian Selic policy rate that was jacked up from 2.00% to 9.25% over 2021. Next week, expect another 150bp hike that should end the Brazilian central bank tightening cycle. Over 2021, 10-year Brazilian rates spiked from 7.50% towards 11.50%. A 1994-style shocking sell off in long rates. If 1994-1995 is our guide, investors should take such attractive levels as a buy-signal.
The impact of the liquidity drain might be less than feared as DM central banks will maintain ample excess reserves. That should contain panic and prevent aggressive widening of investment grade and high yield credit spreads. Credit spread havoc always popped up as financial conditions tightened.
Markets and central banks walked this learning curve many times over the past decade. That knowledge might lead to less stress this time around. Early February 2022, we observe little stress at the long end of the US yield curve. We have observed some overdue spread widening in IG and HY credit markets. We also experienced an overdue correction across Nasdaq, Russell and S&P 500 equity indices.
Expect an intense and steady US hiking cycle over the next 18 months. Expect a peak in inflation readings. Monetary policy is about managing expectations, dixit Chair Powell last week. The art of US central banking reaches new levels of mastery. In hindsight, of course it’s less of a surprise. Listening again to that January 26 press conference, it is clear who is in control and in the lead. The ECB should be inspired. Time for them to tank some confidence and nurture their credibility with more care.