The market is expecting a 75 basis point rate cut by the Federal Reserve after a six-month pause. According to Invesco, the likelihood of that happening is much lower than the market thinks. This is good news for emerging markets, said Wim Vandenhoeck, senior portfolio manager for EMD and global bonds.
Invesco believes the possibility of the Fed pausing for much longer than six months is not sufficiently taken into account. “This is the moment in the cycle to be short dollar and go long on more or less everything else,” said Vandenhoeck. Investment Officer spoke to him at his office on the Hudson River, at the southern tip of Manhattan.
The possible scenarios
Once the effects of monetary policy tightening in the US fully seep into the economy, there is a risk of a significant economic contraction. In that case, the likelihood of an interest rate cut is high.
On the other hand, there is the possibility that future macroeconomic data will point to continued elevated inflation, which would likely lead to another rate hike by the Fed. Currently, US inflation is around 5 per cent, down from over 8 per cent last year. A reduction, but still significantly higher than the long-term average of 3.28 per cent.
According to Vandenhoeck, the tension between these two scenarios, namely the risk of persistent core inflation and the opposite risk of economic contraction, will allow the Fed to remain in “pause mode” for much longer than the market currently expects. ‘As long as the country does not enter a recession, interest rates will not fall.’
No US recession in 2023
“The US unemployment rate, as expressed in Nonfarm Payrolls (NFP), needs to fall significantly to push the country into recession,” said Vandenhoeck. “That will not happen in 2023.”
In April, the US labour market grew by 253,000 jobs. The overall unemployment rate held steady at 3.4 per cent, the lowest rate since 1969. Moreover, there was a significant 0.5 per cent rise in average hourly earnings. Central bankers, both in the US and elsewhere, are concerned about continued wage growth, as they fear it could trigger a wage-price spiral, with higher wages driving up prices and amplifying inflation.
“Given job and wage growth and the relative strength of the US economy, we assume the Fed will park interest rates at the current level of 5 to 5.25 per cent for much longer than six months,” Vandenhoeck said.
“The chances of something happening in the economy that prompts the Fed to do any meaningful easing - 200 basis points or more - are nil in the short term.”
Emerging markets
On average, interest rates in emerging markets are higher than in developed markets, especially in countries such as Latin America, Hungary, Indonesia and South Africa. According to Invesco’s analyses, interest rate differentials are unlikely to again favour the United States. The fund house expects investment in dollars to gradually decline.
“Central banks in emerging markets generally tend to maintain high interest rates or even raise them further. As a result, the nominal interest rate differential with developed markets is expected to persist,” Vandenhoeck said.
This article originally appeared in Dutch on InvestmentOfficer.nl.