THU 05 MAY 2022
From our perch, to describe the policy change by the FOMC today as a “dovish hike” is an oxymoron. To be fair, the Fed was clearly less hawkish than feared. They did not hike by 75 basis points, largely ruled that out in the future and quantitative tightening announced was delayed slightly to June. As we have noted recently, the money markets had already priced more than 300 basis points of tightening into the northern summer of 2023, or a modest overshoot relative to a plausible estimate of the terminal (neutral) Fed Funds Rate.
For equity markets, the way price responded to news also needs to be seen in the context of the brutal drawdown so far this year, especially in liquidity beneficiaries and profitless tech. Nonetheless, it was one of the largest equity market rallies on the day of a Fed hike, since March 2000, at the peak of the last technology bubble. Of course, that was the penultimate hike in the cycle which ended with the federal funds rate at 6.5% in June of that year.
Historically, policy hikes only tend to be challenging for equities once rates move above neutral and growth starts to slow. However, as we see it, the problem is that the Fed does not see the economy slowing and therefore will continue to pound nails (rate hikes) into the (macro) coffin until financial conditions tighten enough to slow inflation. While broad financial conditions have tightened considerably from the low, they remain below average on a normalised basis (chart 1). Put another way the Fed has more work to do. Recall that liquidity moves inversely to volatility. As rates rise and liquidity is withdrawn, cross asset volatility and risk premia is likely to rise.
Jay Powell’s contention on the underlying strength of the economy was tightness in the labour market and strength in household consumption. From our perch that is at odds with leading indicators like new orders, consumer, small business sentiment, housing and the weakness in trading partners (China and Europe). Clearly, ongoing supply constraints contribute to a poor growth/inflation trade-off. The best leading indicators of corporate earnings are already consistent with a contraction in profit growth later this year or early in 2023 (chart 2).
One of the notable features of recent fixed income price action has been the sharp rise in real interest rates (chart 3). Of course, they remain extremely low by historical standards. Looking forward, policy tightening should continue to push real Treasury yields higher by reducing inflation expectations (breakeven inflation). That is what you should expect as policy approaches and perhaps exceeds neutral levels. Although, as we have noted previously, we only really know where neutral lies once the markets break (in 2018 it was at a 1% real Fed Funds rate). Given the relationship between real rates and commodity prices (particularly gold) that could also pose downside risk to commodity prices over the coming months, especially if demand continues to slow. However, the commodity outlook is complicated by the near term weakness in China (related to lockdowns) offset by the infrastructure and credit policy stimulus.
In conclusion, the pricing in terms of short term interest rate expectations appears to be well calibrated or anticipated. On the negative side, the Fed have an incredibly treacherous path to achieve a soft landing. The odds based on history are not great, especially when the Fed does not see the economy slowing. Therefore, they will continue to pound nails (rate hikes) in the (macro) coffin. A rising rate/liquidity withdrawal environment will likely continue to favour companies with low balance sheet leverage and strong cash flow. It is probably not an opportunity to take trash in profitless tech. In the 2000 episode, much of that was wiped out or declined by more than 90%.