During 2022, investors and market analysts have tried many times to call the peak in the US Federal Reserve’s hawkishness. Practically all Fed meetings this year were followed by a temporary drop in rates and a bounce in equity markets. The longest recovery was during the summer as the market considered Powell’s speech after the July Fed meeting to be slightly more dovish. But all these rebounds failed as the Fed board members thereafter stuck to the key message that more hikes were needed to squash inflation. In the last few weeks, markets have finally acknowledged receipt of this key message and all remaining optimism of a quick pivot has disappeared. This is actually good news for the Fed as its efforts to cool down the economy were hampered earlier this year by the lack of passthrough of its hikes. With the continued market rout in September, a 60/40 portfolio (60% stocks/40% bonds – representative asset allocation for US institutional investors) has now lost more than 20% in 2022. Combined with the strong rise of the dollar and mortgage rates, we can safely say that the Fed has succeeded in achieving a significant tightening of financial conditions. So how about that pivot?
The Fed is widely expected to hike at least a total of 100 basis points during its next two meetings in November and December, which would bring its Fed Funds rate to at least 4%. This will make it the fastest rate hike cycle in the last 25 years, and it is no wonder that markets have started to fear the Fed. Other central banks are forced to follow these hikes, otherwise they will face a weakening currency and even higher inflation numbers. The UK LDI crisis last week can be considered as the first major fallout of the global hiking cycle. The sudden dramatic rise of UK long-end yields show that a combination of quick rate hikes, high financial leverage and unsustainable sovereign deficits can cause frightful damage to financial markets. A classic example of Warren Buffett’s quote: “only when the tide goes out do you discover who’s been swimming naked”. The Bank of England quickly provided a blanket to the UK bond market but at the same time warned it will continue to pursue a tighter monetary policy and thus managed to save the pound as well, at least for now.
More trouble on the horizon
We can expect more problems in financial markets in the next few months as the cumulative effect of the rate hikes starts to move through the economy. House prices will drop considerably, taking to account higher mortgage rates. In the UK, you can consider yourself lucky to even get a mortgage now that some major lenders have stopped providing them due to the ongoing rate volatility. Share buybacks, which have supported equity markets for many years, will be reduced as the financing costs have increased and earnings start to fall. At some point, companies will start to decrease their pace of hiring, and the labor market will start to turn, and unemployment will rise. Up to now, the US job market has been surprisingly resilient, with weekly jobless claims still around their lowest levels of this cycle. As US consumers are running out of savings to support their spending and margins remain under pressure of rising costs, we should see a softening of the labor market conditions very soon. I also think that US inflation numbers can start to show some levelling-off in the coming months, so the chances of a Fed pivot in the coming meetings have increased.
Unfortunately, risk assets will not find much comfort in less hawkish Fed comments and smaller future rate hikes. In the last 10 years, investors have had no alternative but to dive more into risk assets and long duration in search for yield. But with two-year US treasuries yielding 4.25%, they now have a risk-free asset available in an ultra-strong currency that offers a decent yield. Even if the Fed stops hiking after its December meeting, the lure of this yield will keep investors from plunging quickly into risk assets. The US bond market will stabilize, as the inflation monster has been slain, but risk assets still must face the accumulated effects of the monetary tightening cycle on the economy. A complete Fed pivot, with rate cuts and a removal of quantitative tightening, would only occur if there is a major accident in financial markets. All this will continue to provide a bearish backdrop during the fourth quarter. We might get our Fed pivot, but in my view, it is still too soon to call the bottom for risk assets.