It is almost a year since the Fed last raised interest rates and signalled a neutral bias to rates. During this period, bond rates have been broadly range-bound, with fluctuations backwards and forwards with data points on the progress of taming inflation. Equity markets have been on a tear since the “Powell Pivot” in October last year. Within this, over the past six months, market expectations of the timing of the first US rate cut have been gradually pushed out from early 2024 (and six cuts this year) to late this year or maybe not till 2025 whilst long run bond rates remain relatively stable between 4.0-4.5%.
Source: Refinitiv Eikon
From Infradebt’s perspective, one of the surprises of 2023-24 is that the Fed has raised interest rates by more than 5% over 2022 and the first half of 2023, and there is seemingly so little pain to show for it.
One theory on why both US inflation and economic growth have been stronger than you might expect is due to the hyper financialisation of the US equity markets. That is, rather than the stock market following the economy, the endogeneity is the other way around, and financial markets lead the economy. This phenomenon has been coined the theory of reflexivity and is a school of thought advocated by George Soros.
The theory is that investor perceptions can drive economic fundamentals in a self-fulfilling feedback loop. This feedback loop can be both on the positive and negative side. At the moment, the prospect of easing monetary policy is pushing equity markets higher and causing a positive wealth effect, stoking economic growth and inflation, which delays the path of rate cuts.
Applying this logic to the macro environment of the past year we can interpret the market tea leaves as the following. The late 2023 Fed pivot to neutral prevented a recession and sees the US economy continue to outperform through the first half of 2024. Investors interpreted the Powell Pivot as a signal to bid stock prices up on expectation of declining discount rates. This in turn creates a positive wealth effect through the economy stimulating demand. Inflation then overshoots expectations, and the bond market gets twitchy.
What does this mean for investors? We are probably in a short-term equilibrium where the economy is slowing and inflation is getting under control. Equity markets will rally and give growth another boost. If inflation surprises on the upside and cuts continue to get delayed, we will see stock prices fall which may hurt the actual economy. This delicate balancing act could go on for a while with the ultimate goal of the Fed to engineer a soft landing – that is get inflation under control without causing a recession (and a steady unwinding of zero rate induced asset bubbles rather than an immediate unwind).
While every tightening cycle is different, history has shown that rising rate cycles don’t necessarily lead to an immediate stock market correction or recession. Since the 1990s the average length between the initial rate increase and the start of a bear market has been 3.5 years and for a recession the average time is 4.1 years. The current rate rise cycle started in March 2022 and based on previous cycles we could be looking at the bear market or recession in 2025 or 2026.
So what is the path of inflation and rates from here? There are basically three options:
The Fed pulls off the ultimate soft landing, with inflation slowing and rates coming down, but no actual recession. It is possible, but history suggests this is rare.
The other two options are:
2. the Fed wins on inflation but loses on growth; or
3. the Fed wins on growth but loses on inflation
If the Fed loses on growth the economy goes into a recession and unemployment rises. Increased unemployment takes heat out of the labour market and wage growth collapses to pre-covid norms. The key issue for equity markets – is that cyclical and consumer stocks exposed to unemployment would get hit by earnings downgrades. A less bullish equity market environment would see CEOs switch from growth to cost cutting, and this would reinforce the slowdown. Interest rate sensitive parts of the market would benefit from lower rates. The trick would be to find stocks whose earnings hold up in a downturn and also are long-duration and so benefit from lower rates. Energy and commodity prices would fall - as a recession hits underlying demand.
If the Fed wins on growth but loses on inflation, then inflation never gets back to 2% and at some point, post the US election, there is a realisation that inflation continues running at 3-4% and rates just aren’t high enough to bring it under control. In this scenario, bond markets definitely (and equity markets probably) would crap themselves (a technical market term). At 4.2% the 10-year bond rate does not make sense if market participants thought inflation was going to be 3-4% long-term. The Fed would either need to launch a second hiking cycle or the bond market would do it anyway. This would be in an environment of incredibly high government spending (both Biden and Trump are big spenders) and could easily be the US’s Liz Truss moment.
The challenge for investors is to stop focusing on the very short term (i.e., this month’s CPI print and the market reaction to that) but instead to take a longer-term view and, in particular, to try and judge what the world will look like in 2025 and beyond.
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