Jerome Powell

The latest ‘chart of the week’ shows a difference between market expectations of what the Federal Reserve will do and what the central bank wants, a fascinating development, says True Insights’ Jeroen Blokland. The Fed as well as the European Central Bank will update their views on interest rates later this week.

Unlike the Federal Reserve itself, investors believe the “Fed pivot” moment is approaching rapidly. Forward swaps point to a peak in interest rates of up to five per cent. Some market experts however are “uncomfortable” with the view and don’t exclude a level of six percent of the US benchmark.

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” .

“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. 

The US Federal Reserve announced an expected 75 basis point interest rate hike on Wednesday evening. Inflation pain will now have to be carefully weighed against the threat of an economic recession. Equity markets reacted positively to the announced policy.  

The S&P added 2.68 percent and the Dow Jones gained almost 1.4 percent. European markets extended Wednesday’s gains in early trading. The Euro Stoxx 50 index traded 0.4 percent higher shortly after the opening.

The Federal Reserve is doing something else than what it says it is doing. At last week’s FOMC meeting, Fed chief Jerome Powell said that “the committee is not trying to cause a recession”. Yet it is clear that the Fed is directly linking a recession to lower inflation risks and that the Fed does want to fight inflation.

The Federal Reserve on Wednesday raised its main policy rate by 50 basis points, the largest increase since 2000. The steep hike reflects the current state of the US economy, where inflation surged to 8.5 percent in March with unemployment relatively low at 3.6 percent.

In what observers labelled as “dovish tightening”, the Federal Reserve on Wednesday evening raised interest rates for the first time since 2018 and flagged that six more rate hikes are coming later this year. Equity markets rallied but with an inverting yield curve, Treasuries reflect hesitation.

Bonds are among the best performing asset classes of the past 40 years. But it’s not unlikely the next 40 years will show a radically different picture. 2021 and 2022 could even yield negative returns as above-average economic growth and rising inflation could push bond yields up from their record-low levels.

The table below shows that bonds have done great over the past four decades. However, returns have fallen steadily from 222.7% in the period 1980-1989, to 109.9% in 1990-1999, to 84.7% in 2000-2009 and to 44.5% in the ten years from 2010-2019.

Investors did not respond to the Fed’s surprise 50 basis points rate cut with a relief rally. To the contrary, markets closed almost 3% lower as investors interpreted the rate cut as a warning the macroeconomic situation is likely to worsen.
 
Fed president Jerome Powell stated shortly after Wall Street opened that the negative effects of the coronavirus are slowly becoming visible.