Stubborn US inflation, delayed Fed rate cuts could mark a painful adjustment for investors

THIS column last broached the topic of inflation and interest rates in December, right after the US Federal Open Market Committee (FOMC) indicated no further rate hikes were likely.

It was a watershed moment for markets: the era of rate cuts had officially begun.

Since then – even before the Federal Reserve has delivered a single rate cut – expectations about the pace and magnitude of US monetary policy loosening have been dialled back in the face of stronger-than-expected economic data.

Earlier this month, for instance, the United States jobs report for March showed the pace of hiring had accelerated. Total nonfarm payroll employment rose by 303,000, higher than the average monthly gain of 231,000 over the prior 12 months.

January’s nonfarm payroll gain was revised up to 256,000, while the corresponding figure for February was revised down to 270,000. With the revisions, the combined employment gain in January and February was 22,000 more than previously reported.

Then came the hotter than expected US inflation data last week. On Wednesday (Apr 10), the US Bureau of Labor Statistics said the headline consumer price index (CPI) rose 3.5 per cent for the 12 months ended March, up from 3.2 per cent for the 12 months to February.

The CPI, excluding its food and energy components, was up 3.8 per cent for the 12 months to March, unchanged from February.

The energy component of the index increased 2.1 per cent for the 12 months ending March, the first 12-month increase since the period ending February 2023.

With the acceleration in inflation, some traders now expect only one or two Fed rate cuts in 2024. At the beginning of this year, I recall some traders were expecting more than five rate cuts.

One Fed official said last week that inflation data since the beginning of this year does not support the case for looser monetary policy.

The 10-year US Treasury bond yield pushed above 4.5 per cent last week, following the release of the US inflation data. The S&P 500 Index closed Friday at 5,123.41 – down nearly 1.6 per cent for the week.

New ‘new normal’?

Despite the steep rise in interest rates since 2022, the US managed to achieve remarkably resilient gross domestic product (GDP) growth of 3.1 per cent last year.

This was partly due to pent-up demand from savings accumulated during the pandemic. Easing supply chain bottlenecks and rising labour force participation rates also supported economic expansion while allowing inflation to decelerate.

These factors might still be at play. FOMC meeting participants last month projected US GDP growth of 2.1 per cent for 2024, and 2 per cent for 2025 and 2026.

This is higher than their projections in December last year, which put US GDP growth at 1.4 per cent for 2024, 1.8 per cent for 2025, and 1.9 per cent for 2026.

“Participants generally revised up their growth projections since December, reflecting the strength of incoming data, including data on labour supply,” said Fed chair Jerome Powell, during a press conference after the FOMC meeting last month.

These upwardly revised growth projections still represent a slowdown compared with 2023, of course.

The FOMC meeting participants kept their projection for the federal funds rate by end-2024 unchanged at 4.6 per cent, which implies three 25-basis-point cuts.

Their projections for the benchmark rate by end-2025 rose to 3.9 per cent, though, from 3.6 per cent in December. Their projections for the benchmark rate by end-2026 rose to 3.1 per cent, from 2.9 per cent.

This raised questions about whether the US economy now requires structurally higher interest rates than in the recent past, and whether the era of ultra-loose monetary policies that followed the Global Financial Crisis is at an end.

“I don’t think we know,” Powell demurred.

“My instinct would be that rates will not go back down to the very low levels that we saw, where, all around the world, there were long-run [real interest] rates that were at or below zero in some cases. I don’t see rates going back down to that level,” he added.

Even if a new “new normal” for monetary policy is not in the offing, however, my view is investors should prepare for a painful shift in market consensus on the extent to which interest rates will soften in the months ahead.

If inflation takes longer than expected to subside, the federal funds rate may well stay above the 4 per cent threshold all the way into 2026.

Bad news for Reits

Without the tailwind of immediate interest rate cuts, there is likely to be more intense investor scrutiny of corporate profitability and stock valuations in the remaining months of 2024.

The S&P 500 has climbed 7.4 per cent this year. Factset said in a report last week the S&P 500 is now trading at about 20.6 times forward earnings. Its average forward price-to-earnings ratio was 19.1 times over the last five years, and 17.8 times over the last 10 years.

A more hawkish Fed could make it harder for other central banks to ease monetary policy without putting their currencies at risk. In this region, precipitous depreciations of the Indonesian rupiah and Malaysian ringgit have made headlines in recent months.

The US dollar index – which measures the US dollar versus a basket of major currencies – has climbed 1.6 per cent over the past week and 4.6 per cent since the end of last year.

A strong US dollar might also be bad news for some US-listed companies that earn significant chunks of their revenue overseas. Among them are household names such as Apple, McDonald’s and Nvidia.

Here in Singapore, a bearish shift in interest rate expectations could be very bad news for real estate investment trusts (Reits). These structures all carry a certain amount of debt that is never paid down but refinanced from time to time.

In a recent Mark To Market podcast, my colleague Raphael Lim and I discussed how this has led to some Reits being caught with too much leverage in the wake of the steep rise in interest rates over the last couple of years.

While the three rate cuts pencilled in by the Fed back in December would not have been sufficient to save the whole sector from a tough period of deleveraging, the cuts might have helped revive investor sentiment towards the stronger Reits that have been beaten down.

A resurgence of inflation that keeps interest rates higher for longer will probably push back a recovery in this popular segment of the local market.

The Mark To Market column will take a break next week while the writer clears some leave.