Chances of a real turn in short-term interest rate policy seem to have been squandered since yesterday. According to specialists at Aegon AM, PGIM and T. Rowe Price, interest rates will remain high for several more quarters. A quick reversal in interest rate policy is unlikely. So is an early return to “normal” .
The Federal Open Market Committee decided yesterday, after its two-day meeting, to raise policy rates by 75 basis points to 4 per cent in an attempt to halt record inflation. While the interest rate hike was expected, the Federal Reserve’s decision ended both this week’s impressive rally and dimmed investors’’ hopes for a sustained recovery in markets in the foreseeable future.
Pausing interest rate hikes is “premature”, Fed President Jerome Powell told the press afterwards. “Risk management is the key here: if we are too tight, we can use our tools to support the economy later; but if we are not tight enough, inflation will lock in and that would be a much bigger problem,” Powell said.
His statements caught investors off guard. After an initial rise, the Dow Jones, the S&P500 and the Nasdaq shed 1.6 per cent, 2.5 per cent and 3.7 per cent, respectively. The market now expects interest rates to rise even further than the previously predicted 5 per cent in the first quarter of 2023.
It’s all about the labour market
“The Fed will not pivot until the labour market is fully normalised,” said Robert-Jan van der Mark, portfolio manager for multi-asset investments at Aegon AM. He believes the labour market is the key indicator of a potential turn in interest rate policy, the so-called “pivot”.
“Stopping interest rate hikes too early could create additional inflationary pressures and reputational damage,” said Van der Mark.
The Fed will do everything it can to reverse upward pressure on wages, according to Aegon AM. That is caused by the US labour market where there are currently two vacancies open for every unemployed and job-seeker.
That labour market showed no signs of normalisation in September. The US is struggling with strong wage growth and increasing demand for workers. The Fed’s strategy - cooling the economy with interest rate hikes - is clearly not yet working through sufficiently in the real economy. This is bad news for investors as only a pivot will be able to give investors more air in this tough investment environment.
“Our expectation is that policy rates will peak in the first half of 2023,” Van der Mark said. “According to our estimates, unemployment should rise at least 1.5 per cent from the current level of 3.5 to better match labour supply and demand.” Aegon AM also expects that interest rates cannot be cut by the Fed before 2024.
Reasons for optimism
Robert Tipp, chief strategist and head of fixed income at PGIM, is also concerned that persistently high inflation rates and strong job growth will cause central banks to continue aggressively raising interest rates. “That will fuel fears of a hard landing,” Tipp said in PGIM’s outlook for the fourth quarter.
Tipp: “If growth and inflation remain higher than expected, interest rates could rise another percentage point. Second, due to low global unemployment and the expectation that a return to targeted inflation is likely to take some time, interest rates could remain at high levels for several more quarters - a quick turnaround may not happen this time.”
Although negative developments still prevail, according to Tipp, “there is still reason for optimism”. Taking into account the delayed effect of previous rate hikes and those that appear to be coming in the coming months, Tipp said investors should expect the peaks in growth, inflation and thus long-term interest rates to be near.
Corporate bonds will be the first to benefit
“As we have seen over the past period, financial markets do stand to benefit already,”Van der Mark said. “Every time there were signals in recent months that the Fed pivot was approaching, stock prices shot up.”
In the past, the peak in long-term interest rates was usually reached earlier than the trough in equity markets. This means that long-term government bonds will initially become more attractive. Van der Mark believes that first the other categories within fixed income will benefit, corporate bonds first.
“Only after that will equity markets benefit,” said Van der Mark. “We expect growth stocks to benefit the most in this scenario. In addition, the Fed pivot would also end the US dollar’s rally. Exchange rate risk could therefore then have a negative impact for European investors.”
This article originally appeared on InvestmentOfficer.nl.