On January 1st, the market was pricing in a Fed Funds rate of 0.8% for the end of 2022 or about three rate hikes over the year of the 25bps tenor. Fast forward to today, the futures now price in 2.5% at year end or eight to nine hikes. Given there are six meetings left this year, that means a few hikes will have to be twofers. We have not seen one of those in the hiking direction since May 2000—coincidentally around the end of the tech bubble (don’t worry, this isn’t that).
Most would probably agree that central banks left overnight policy rates too low and remained active with quantitative bond buying (QE) for too long. Or more simply, that they remained uber dovish for too long, even as economic growth recovered and inflation pressures intensified, because of the pandemic.
This comfort in remaining dovish was well founded given longer-term inflation expectations and near-term market pricing. This has been changing this year, and the pivot from dovish to hawkish, which has really just begun, is clearly warranted. But the market might be already getting a bit carried away with the degree of hawkishness, which is not an uncommon occurrence.
Are we suggesting to ignore what central bankers are telling us with their speeches and little dots? Not at all. But also, don’t ignore the fact that the market is tightening financial conditions in response to those speeches and dots, even before the Fed actually does much tightening themselves. If you can get the market to effectuate your desired outcome, well played. Why not lean into the faster tightening talk?
Yes, inflation continues to be a big issue. And while the impact of the Covid supply disruptions might be starting to fade, we now have conflict inflation pressures to absorb. Central bank policy cannot affect supply issues, although reducing economic growth helps inflationary pressures from the other side of the ledger. And the headwinds for economic growth are mounting:
- Oil prices – It is estimated that a $10 dollar change in the price of oil creates a 0.1% drag on global GDP growth. Dollar oil is an incremental tax on consumption and global GDP. Oil averaged $70 in 2021, using the Brent contract. So far this year, it has averaged $100, which is also the current price. If that is an 0.3% drag on global GDP, it’s not great but not too bad with current forecasts around 4.0%.
- China – While always challenging to get an accurate gauge on economic activity, China continues to feel the impact of Evergrande within the real estate market. Although clearly not scientific, we monitor a basket of developers listed in Hong Kong or China as our indicator of the health of the industry, which suggests things are not getting worse but not improving either. Add to this many imports, volumes have started to dip lower. Data tends to be a bit wonky this time of year, but it’s still noteworthy. As are iron ore and coal exports from Australia. And then there is Europe…
- Europe – The war and associated economic disruptions may tip Europe into negative economic growth. Still a way off but this is the part of the global economy most impacted. Over the past few months, 2022 consensus growth has fallen from 4.2 to 3.0%. Slowing European markets is also not good for China, as trade between the two is significant.
- Yields – Much commentary focuses on what central banks are up to with the overnight rate but longer yields probably matter more. And they have certainly been rising. Nominal yields are easy enough to notice, with 10-year yields in Canada and the U.S. in and around 2.60%. Potentially more impactful though is that real yields are quickly approaching zero. The 10-year real yield in the U.S. has been deeply negative (-0.5 to -1%) since the onset of the pandemic. Or look at mortgage rates, all of a sudden, those houses that appeared on the edge of affordability have moved deeply into the “can’t afford it” category.
We are not saying “recession”—as clearly outlined in our monthly strategy section, ‘Reports of my death are greatly exaggerated’ (read here + scroll down a bit)—but you better believe an economic growth scare is coming. And that is a good thing as it will help alleviate inflation pressures; it will allow central banks to back off the peak hawkishness path the market is now pricing in.
Investment Implications
As economic growth cools, which we are already starting to see some evidence is taking place, the demand side of the inflation equation begins to ease the pressure. It may be later this year given Covid and now conflict supply issues, but it is likely coming. And with it a less hawkish path for central banks.
Yields may climb further but we would continue to use this rise in yields to incrementally add some duration for those portfolios that remain low or void of duration exposure. Or within equities, to focus less on cyclicals and rotate more to defensives or equities with higher duration. Rising inflation, rising yields, hawkish central banks, high commodity prices and slowing economic growth – something’s gotta give.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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