FRI 11 FEB 2022
Since 1913, 90% of Fed rate cycles have ended in recession. On the positive side, as we have noted before, the real damage from higher rates tends to occur later in the cycle when tighter policy flattens/inverts the curve. Of course, following another upside inflation surprise and a very elevated headline and core print in January, the impulsive rise in short-term interest rate expectations and the front end of the yield curve, has contributed to a material recalibration of beliefs.
For markets, it has the potential to be a proper cluster-struck from a value-at-risk or volatility perspective. The December 2022 Eurodollar contract is now trading at just under 2% (in terms of the implied yield) which implies 7 rate hikes of 25 basis points by year end (chart 1). Of course, it also increases the odds that the Fed delivers a 50 or 75 basis point hike in March. While there has been an impulsive, rapid and emotional re-pricing of front end rates, the re-calibration of longer term rate and inflation expectations remains relatively well contained. More now, still appears to equal less later. The 16th Eurodollar contract or a proxy for terminal/neutral rates (r-star) is 2.25% and 5 year, 5 year forward breakeven inflation still relatively well anchored modestly above 2%.
On the negative side, the greater movement at the front end is flattening the yield curve which is a potential signal that the recession odds noted above will eventually play out. Our sense is that some market participants might be too pessimistic on the potential growth shock later this year. However, as we noted earlier this week, other market signals such as the relative performance of small companies and some more stock-specific examples suggest that there might be a pay-back from the pull-forward of demand/inventory build last year. That is also evident in consumption and retail spending (in real and nominal terms) that has been well above trend (chart 2).
The good news on the headline inflation front is that there is some evidence in leading indicators like ISM prices paid, that goods price inflation might be somewhere near peak. The base effects also ought to ease year-on-year inflation over the next few months. However, as we have consistently noted, inflation has been a driven by a function of both excess demand and the global supply shock. As a result, the Fed and most central banks are materially behind the curve on just about every measure of monetary policy conditions. Indeed, based on the difference between the nominal 10 -year Treasury yield less headline inflation, the real yield is now the most negative since the 1970s (chart 3).
For markets, the key point is that the Fed probably has to respond in a more forceful manner on policy rates and the balance sheet run-off. From our perch, the policy error has been to leave normalisation too late, thereby exacerbating the potential shock to financial conditions. It is a potential cluster of biblical proportions (in volatility and liquidity terms) for markets.
For portfolio construction, it reinforces our bias to prefer entities with (short duration) cash flow and low balance sheet leverage. It has also underlines the short-coming of fixed income as a diversification for equity. We have also used the rally in equity more broadly to reduce net long exposure. Within equity, we continue to prefer banks as an inexpensive, positive carry diversifier against higher yields. The good news is that Asia Pacific trades at a record discount to US equities and the current rate shock is now much better appreciated and priced. However, the potential value-at-risk shock is non-trivial. Hopefully, inflation conditions do improve over the coming months.