Yesterday the Fed held its target benchmark rate at 5.25%-5.5%, as had been expected. Yet Treasury yields rose, and U.S. stock markets fell, as if investors had been surprised by a rate hike.
The stale, over-long post-Covid economic cycle just wont die. As long as labour markets remain strong, and consumption robust, the 2% inflation target is a chimera. The Fed is as baffled as everyone else regarding the duration of the cycle, after 18 months of rapid interest rate hikes.
But the Fed has a solution: to just keep going. And yesterday we saw financial markets believe that it will, in fact, do this.
The evidence was in the dot plot chart of FOMC member’s expectations for interest rates. This shows 12 of the 19 policy makers now favouring a further hike before the year end. If anyone was in any doubt that the Fed is adopting a ‘higher for longer’ strategy, it is there in the dot chart: rate cuts are now not expected until spring of next year, at the earliest.
The duration of the post-Covid economic cycle, and the resulting sticky inflation, has surprised everyone. It explains the continued pushing-out of peak interest rates, and delays to subsequent interest rate cuts by the FOMC.
The longevity of the current economic cycle also pushes out the point of ‘peak gloom’ in the economy, a possible sell-off of risk assets on financial markets, and the start of a new economic cycle. The post-Covid economic cycle has become stale, but it won’t die.
Yesterday, the Fed suggested that this economic cycle has yet further to go, doubling its GDP growth estimate for this year to 2.1%, and increasing its 2024 estimate from 1.1% to 1.5%. By way of comparison, second quarter 2023 GDP came in at an annualised rate of 2.4%.*
The rise in unemployment, which many economists see as being necessary to control wage growth and so bring down core inflation, will be slower than previously expected. Currently 3.5%, it is expected to hover around 4.1% next year and 2025.
Not necessarily a soft landing
The above growth and unemployment numbers would suggest a soft landing for the U.S. economy, but only if inflation is brought down to the 2% target simultaneously. Here lies the problem: while inflation is expected to continue to fall over the next two years, the Fed estimates it will reach 2% only in 2026. After all, an unemployment rate of 4.1% is still tight by historic standards.
The Fed is balancing its growth and price stability mandates and finding growth has the upper hand. It is trying to rectify this through signalling ‘higher for longer’ interest rates, while mindful that the economy may adjust anyway. Jay Powell repeatedly reminds us that previous rate hikes take time to fully impact on the economy.
In addition, the resumption of student loan repayments, the winding down of excess savings, the unresolved strikes affecting the motor industry, and the threat of a shut down of government services, may do the Fed’s work for it. In which case, ‘higher for longer’ risks causing a recession and much higher than anticipated unemployment. (at least, then, the stale economic cycle will be truly over).
Implications for investors
Treasury yields look generous, with the 2yr at 5.2% and the 10yr at 4.4% (as at 4:30 a.m. CET today). With CPI inflation in July at 3.2%, and forecasted to fall over the coming years, real returns are positive and are likely to get better.
The caveat is, of course, that nominal yields have been looking attractive for much of the year. But they have continued to rise, as the ‘higher for longer’ theme has turned from speculation, to implied Fed policy, to -as we saw yesterday- actual policy.
Risk assets look less certain. Their robustness this year, with the S&P500 up 15% since January 1, reflects the surprising duration of the current economic cycle and decent corporate earnings growth. If the Fed’s ‘higher for longer’ interest rate policy proves to be overkill, given the other factors mentioned above that might curtail consumption, then a whiff of recession may well trigger a sell of in stocks and other risk assts.
A multi-asset balanced fund will give investors exposure to a variety of asset classes, and regions, and so limit the downside risk to investors capital. Financial history shows that such an approach delivers the best risk-adjusted returns over the long term.
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