“Walking the narrow path” is an expression among central bankers about striking a fragile balance between reining in inflation and not plunging the economy into the ravine. Friday showed how difficult that task has become.
Investors who had expected a turnaround in monetary policy and “business as usual” are in for a rude awakening. Central bankers unanimously delivered a hawkish message at the Jackson Hole Symposium last week to further tighten monetary policy in the near future. Like Federal Reserve chief Powells, the governors of the central banks of the United Kingdom, Switzerland, Japan, Korea and also several members of the ECB left no room for doubt: fighting inflation is the priority.
In concrete terms, this means that the series of interest rate rises is not yet over, that further substantial interest rate rises are in the pipeline and that the economy could well end up in a major recession. Investors now can delete the word “soft landing” from their vocabulary.
Markets extending losses on Monday
On Friday, this led to substantial price losses on Wall Street on Friday evening, up to 4 percent. European markets followed through with that drop, trading more than 1 percent lower early on Monday, although equity markets have not given up the gains they booked during their summer rally in July and August.
An interest rate increase of 75 basis points in September now seems to be a quasi certainty. For many investors, Friday’s statements came as a surprise, despite the psychological preparation that had been going on for months. A return to the situation since 2008, with ultra-loose monetary policy, non-stop QE measures and cheap money, now seems definitely behind us.
This can also be seen in the interest rate evolution. US two-year yields hit their highest level since 2007 after Powell’s hawkish comments. The two-year interest rate in the US has now reached 3.46 percent. That is the highest level since November 2007, the period before the Great Financial Crisis of 2008-2009. It was literally a different era then.
Catch 22
The consequence of the “narrow path” taken by central bankers is that many debt-laden countries, governments and companies will find it even more difficult in the coming years. If central bankers remove the bailout bonds, investors fear that many companies and governments will no longer be able to meet their financial obligations. This will also push up unemployment rates, especially in Europe, which is already hugely vulnerable due to the precarious energy situation.
Frank Vranken, chief strategist at Edmond de Rothschild Europe, clearly states that we should not expect interest rates to be cut in the near future. However, the markets had factored in rate cuts between March and December next year. In other words, it does not look like there will be a Fed pivot. According to Vranken, the Fed remains data-dependent, but wants at all costs to avoid repeating the mistakes of the 1970s, which triggered an inflationary spiral. Then the interest rate hikes were stopped too soon and this allowed inflation to pick up again, which afterwards caused even more misery.
ECB pressed to hike 50-75 bp next week
When it rains in the United States, it drips in Europe. No matter how vigorously the Fed has acted, the ECB is still dragging its feet. This is not sustainable, said Vranken. A 50bp rate hike now looks like a minimum at the 8 September ECB meeting. Dutch central bank president Klaas Knot, speaking on Dutch television from Jackson Hole, again alluded to a possible 75 basis point hike.
Futures markets are now discounting rate hikes of 120-130bp for the end of this year, bringing the benchmark eurozone rate to between 1 and 2 percent.
Leadership
Philippe Gijsels, chief strategist of BNP Paribas Fortis, wonders which sectors could take over leadership in a new bull market. He identifies them by their relative strength and technical evolution. “Healthcare, biotech and alternative energy, especially solar, show relative strength. Those sectors could lead in a new upward movement,” he said.
Conclusion: the narrow path will become even narrower. Investors who had counted on it being “business as usual” will have to change their thinking.
A video of Powell’s speech is available on the Youtube channel of the Kansas City Fed, which hosted the Jackson Hole meeting.
This article first appeared in Dutch on Investment Officer Belgium.