Fed may not be as hawkish as it seems
Since the beginning of this year, global financial markets have been very depressed. Major stock indices around the world have fallen by 5-10% amid higher investment risks derived from three factors:
– First, inflation risk: Although we see evidence that some of the supply chain problems that were pushing up prices are starting to ease, some other major factors causing rising inflation still persist.
The huge number of ships waiting at Long Beach Port in Los Angeles and Rotterdam in the Netherlands is finally declining. Inventories in the US are rising, meaning more businesses now have what they need to make products to fill order backlogs.
Also in the US, growth in house prices is decelerating and claims for unemployment benefits are falling. This indicates that inflation pressure from rents and wages may be reduced in the future.
However, rising crude oil prices, which touched a seven-year high above $90 per barrel this week, will be a key contributor to higher inflation going forward.
– Second is the risk of tightening monetary policy. The Federal Reserve has sent clear signals that it needs to respond to stem the rise in inflation expectations. The latest market view is that the US central bank’s first interest-rate increase in March will be 50 basis points, double the normal figure. Economists polled by Bloomberg see five hikes totalling 125 basis points this year.
Apart from higher interest rates, we are concerned about so-called quantitative tightening (QT), the opposite of the quantitative easing that has been the norm for the past two years.
The minutes of the Federal Open Market Committee (FOMC) meeting on Dec 14-15 indicated that QT, or a reduction in the Fed’s balance sheet, will begin shortly after the first rate hike, and will have to be more intense than in 2018-19.
The main reason for a faster pace of tightening is to prevent the US bond yield curve from flattening or inverting, which is a leading indicator of economic recession. A flattening yield curve means financial institutions earn less interest income (which moves in accordance with longer-maturity bond yields) while having higher interest expense (due to rising short-maturity bond yields). The narrower net interest margin pushes banks to lend to higher-risk borrowers, who are charged higher rates, to pad their margins. But this is imprudent and can heighten the risk of a financial crisis.
But we see a flip side to this situation: By hiking its policy rate and paring its balance sheet during an economic down-cycle, the Fed risks causing a recession. This is due to the concept of the debt service coverage ratio.
If the revenue growth of a business (or country) exceeds interest and principal expenses, it still has cash left to pay interest.
But if income is lower than the interest expense, then the business (or country) will run out of liquidity and face financial problems.
– The third and final risk is geopolitical. This risk has risen sharply in light of relatively soft US positions of late. Major potential flashpoints now include Ukraine, where 110,000 Russian troops are at the border and talk of an invasion is growing despite Moscow’s denials; worsening tensions between China and Taiwan; and uncertainty about the outcome of the nuclear non-proliferation talks with Iran. The Ukraine and Iran issues in particular are contributing to high energy prices.
GLIMMER OF HOPE
Nevertheless, there is some light at the end of the tunnel. After analysing the results of this week’s Fed meeting, we have different view than the market. Unlike many, we do not see the Fed signalling a strong tightening of monetary conditions, for three important reasons:
– Although the Fed signalled its first rate hike in March, chairman Jerome Powell has indicated that increases will be modest and will respond quickly to the relevant data, especially inflation. This suggests that the Fed may not be in a hurry to hike interest rates as much as some now believe.
– The Fed also confirmed that it will end QE in March as signalled earlier, while some have suggested that it could be finished with its bond-buying stimulus even sooner.
– The Fed signalled that QT will begin after interest rates start rising. The market interprets this to mean that May may mark the start of the balance-sheet reduction.
While the market sees the QT timeline as a signal of tighter than expected conditions, we see two interesting points: Mr Powell is focussed more on interest rates as a tool to maintain economic stability; and QT will simply involve not rolling over maturing bonds, as opposed to actively selling bonds in the Fed’s portfolio.
This indicates the Fed wants to keep long-term yields from rising too quickly.
In summary, while the market saw last week’s Fed meeting as hawkish, in our view it was quite dovish and more or less data-dependent. And the reactive QT approach, by letting bonds expire, in contrast to actively selling, will not drive long-term yields high.
The downside risk of this approach, however, is the flattening of the yield curve, which runs counter to the signal from the December Fed minutes.
This contrasting signal, in our view, needs to be resolve soon. We believe the minutes of this week’s meeting, which will be released on Feb 17, should offer more clarity.
In the meantime, we have to closely monitor employment figures as well as other important indicators including inflation, which is still high amid increasing risks both from higher financial costs, oil prices and geopolitical risks.
These factors are all reflected in the latest forecast from the IMF, which has downgraded its US growth forecast for this year significantly, to 4.0% from 5.2%, due to several factors.
The slowing economic momentum may lead to lower inflationary pressure, which translates into a reduced need for tighter financial conditions and thus a more accommodative investment environment.
In any case, economic indicators are really important at this juncture. Analysts, strategists, investors and businesspeople are urged to be observant.