Date Published
2 February 2022

Article Posted by
Andrew Kinsey

The Macro View (monetary policy)
U.S. equity markets took fright in January, interest rates could rise seven times before the end of 2023

Synopsis:

Today, raising key policy rates off the zero bound leaves as much room for error as threading a camel through the eye of a needle. As we have seen in January, U.S. equities have taken fright. We have little confidence in the Fed. Stay tuned though for our forthcoming note which against the backdrop of this latest context will update readers on our two inhouse hypothetical investment portfolios.

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 The Macro View – monetary policy
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“Threading a camel through the eye of a needle?”

In “The Fed’s last stand, or not?” we pointed out that the U.S. Federal Reserve has been politicised into a monetary U-turn. But the Fed hasn’t a good track record since Paul Volcker and this time things are far trickier, as we explained. Alan Greenspan, from whom we quote in this latest note, neatly sidestepped any Fed responsibility for fanning the flames of multi-asset bubbles. Officials with no skin in the game are hardly the stuff of confidence for seasoned bond market investors. Today, raising key policy rates off the zero bound leaves as much room for error as threading a camel through the eye of a needle. As we have seen in January, U.S. equities have taken fright. The Fed is tilting towards raising rates by as many as seven times before the end of 2023, implying a Federal Funds rate of 2%. The 2-year Treasury yield, a key indicator, has been moving up. And the curve is getting closer to inversion. Our readers will be familiar with the hypothetical equity portfolio that we’ve been running, and we’ve recently added a second. The mechanics and operational features of these portfolios will be the topic of a forthcoming note.     

The U.S. Federal Reserve has signaled that the days of easy money over 13 years may actually be over. A U-turn is underway.

The Federal Reserve has been stirred to action…. and equities are taking a hit!

The Federal Reserve’s bond buying program, which has propped up the biggest asset bubble in history, is scheduled to end in March 2022.

Judging by the statement from Jerome Powell on 26 January, after the conclusion of the January 2022 FOMC meeting, the markets need to start adjusting to a higher interest rate regime over the next 24 months.

The Federal Reserve is tilting towards raising rates by as many as seven times before the end of 2023. In my opinion it is very unlikely that each rate increase will not exceed 25 basis points (bps).

That would take the Federal Funds Target Range (Upper Limit) to 2.00%, which is still 50 bps below the peak of rates reached in December 2018.

Federal funds rate and target rates

The U.S. 2-year note yield moved higher by 18 bps in anticipation and the wake of the announcement. At the same time the 10-year note yield rose by 8 bps, narrowing the yield spread between them to 72 bps.

10-year yield minus 2-year yield on Treasury notes versus Federal Fund Rate

As we have stated repeatedly in our previous reports, the 2-year yield is the most responsive of term bonds in anticipation of movements in the Federal Funds market.

The further out we go in the curve, yield curve moves are dominated by shifting assessments of inflation, credit, economic growth, and employment, to name but a few principal factors.

That investors are prepared to accept deeply negative real rates of return in the long end is in my view a pricing of less ominous average inflationary conditions over the term to maturity of those bonds and /or less confidence in strong growth for the economy over the same period.

In the past twenty years the occasions of approximate or actual yield inversion between the 2-year and 10-year notes have been when the Federal Reserve has been at or close to a top in their rate hike cycle.

This time around before the Feds have even touched the launch button on Fed Funds, the 2’s to 10’s part of the curve is within 75 bps of inversion. 30’s versus 10’s is an even more perilous 38 bps

I don’t know whether to be completely alarmed by the rates condition or just wait with dread, witnessing how badly the FOMC will handle the optics of and public narrative over their missteps in the next two years. 

Interest rate conditions then are seemingly from another universe when compared to the world in which live now.

As we have also said numerous times before, raising key policy rates off the zero bound leaves as much room for error as threading a camel through the eye of a needle. Especially when the asset markets have become accustomed to and dependent upon free money.

As the chart above illustrates, the Federal Reserve embarked upon a concerted rate hike program in late 2004, reacting belatedly to an already overheated U.S. property market which when combined with the blow torch of excessive leverage all along the property market pipeline led directly to the Global Financial Crisis, which started in 2007.

The Federal Reserve (and for that matter other globally significant central banks) are about to face another acid test.

Are they able to return to a more conventional monetary policy regime without critically undermining asset markets, which are by all reasonable measures overpriced in the extreme?

In my opinion, the potential fragility of the markets may be laid squarely at the door of the Federal Reserve and its acolytes.

Consider this extraordinary irony from the master of doublespeak and revisionism, former Federal Reserve Chairman, Alan Greenspan.

In 2002, defending the Federal Reserve’s role in the dot.com bubble of the late 1990’s he said this:

”As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact — that is, when its bursting confirmed its existence,” he said. ”Moreover, it was far from obvious that bubbles, even if identified early, could be pre-empted short of the central bank inducing a substantial contraction in economic activity, the very outcome we would be seeking to avoid.”

In a January 2018 television interview, Greenspan opined:

“I think there are two bubbles. We have a stock market bubble, and we have a bond market bubble,” Greenspan said. “I think [at] the end of the day the bond market bubble will eventually be the critical issue.”

He reaffirmed his view at the end of March 2018. In October the 10-year bond topped out at 3.25% and traded as low as 1.45% in the last quarter of 2019, before the COVID-19 outbreak. 

And this gem from October 2021:

“The tendency toward inflation remains, unfortunately, well above the average of about 2% over the past two decades,” he said in the note on overshooting the Fed’s target.

Yields on the 10-year Treasury note is below the levels they were pre-pandemic levels, he pointed out, suggesting that the financial market may trust in the Fed’s ability to guide the country towards economic recovery with the emphasis my own.

So, to decode this last bit of sagacity from the man, the ‘bond bubble’ of 2018 (10-year rates were at 2.45%) has been replaced by blithely assuming the bond market takes it lead from the Federal Reserve in whom they, the bond market, have an overarching trust to get things just right.

Billion-dollar bond portfolio managers taking their lead from people who have no skin in the game? Sounds unlikely to me.

In truth, Greenspan has no idea of what is going to happen and neither do his successors at the Federal Reserve.

The financial press is full of stories as to what the balance of financial risks are going forward into 2022 and 2023. Top of the list is quite naturally inflation. My top of the pops are serial errors from the central banks as they wean markets off the opioids of free money and bloated balance sheets.

This view leads us easily into what will be the content of my next note. Long-time readers of ours will be familiar with the hypothetical equity portfolio that I have been running over the last 18 months. A collection of a large cap U.S. stocks and a 10-year treasury futures position make up the basic portfolio.

That portfolio is benchmarked against a blended S&P 500 and government bond ETF position.

Another portfolio has been assembled with exactly the same stocks, in exactly the same proportion as the first portfolio, but with a smaller treasury futures position. The balance of funds is dedicated to purchasing quarterly S&P 500 put option overlays to protect the composite portfolio in the event of a large drawdown in the equity market.

A forthcoming note will deal in considerable detail with the mechanics and operational features of the two portfolios and the blended benchmark. There are some very interesting outcomes to discuss.