Don’t fight the Fed because this time could really be different
AFTER the release of data last week that showed a much-higher-than-expected 9.1 per cent year-on-year increase in the US consumer price index, Wall Street is now pricing in a 30 per cent chance of a 100-basis points rate hike at next week’s Federal Open Markets Committee meeting.
Whether or not the data between now and then justifies raising rates by a full percentage point remains to be seen, but the big question of course is: what next?
With unemployment at 3.6 per cent and interest rates still at ultra-low levels, there is a lot of room for the Fed to hike. Even with a 100-points hike, the absolute level of the federal funds rate will still be only at an upper bound of 2.75 per cent.
For equity investors, it would be wise to bear in mind the axiom “don’t fight the Fed’’. In its simplest form, this means investors should buy stocks when interest rates are cut and sell them when interest rates are raised. But there is a deeper meaning at play here, one which recalls a second popular market axiom: “this time is different’’.
Since the 2008 US sub-prime crisis, investors have routinely taken monetary tightening measures in their stride. There may have been “taper tantrums’’, periods of brief market instability, but these have typically been followed by a return to business as usual, with a focus on positive earnings and economic growth.
Why this time could be different is because the Fed has proven spectacularly wrong with regards to inflation. Having repeatedly dismissed rising price pressures as “transitory’’ for most of last year when the data suggested otherwise, the US central bank is now striving to right its wrong call with rapid rate hikes that are not only unsettling markets but are also threatening to tip the economy into a recession.
Most notably, the US Federal Bank of New York in its June forecast stated that “the probability of a soft landing - defined as 4-quarter GDP growth staying positive over the next 10 quarters - is only about 10 per cent’’.
“Conversely, the chances of a hard landing - defined to include at least 1 quarter in the next 10 in which 4-quarter GDP growth dips below -1 per cent, as occurred during the 1990 recession - are about 80 per cent.”
It is entirely possible that the US economy is already on the brink of a recession – as of Jul 15, the Federal Reserve Bank of Atlanta’s GDPNow model estimate for real GDP growth in the second quarter of 2022 was -1.5 per cent. This, after the economy contracted 1.5 per cent in the first quarter.
Add to this a US Treasury yield curve which inverted last week, a position which is widely thought to signify an impending recession, and it is easy to see why this time rate hikes could prove very damaging.
Furthermore, why this time could be different lies in the fact that if the US economy is heading for a contraction as many are predicting, it is occurring during a period of concerted monetary tightening, and not loosening as with previous downturns.
Without room to manoeuvre with regards to cutting interest rates, it is difficult to see how the Fed can engineer a much sought-after soft landing. All of which suggests that investors would do well not to fight the Fed because this time could really be different.
