Anticipating the end of US Fed’s tightening cycle

AS THE US Federal Reserve’s rapid rate-hike cycle winds down, how should investors ready themselves for the plot twists ahead?

The Fed raised the Fed funds rate 11 times since March 2022 to combat inflation precipitated by the Russia-Ukraine war. The Fed funds rate is the interest rate charged by depository institutions such as banks, savings and loans and credit unions for overnight loans.

The sequence of 25-basis-point (bp) to 75 bps hikes per consecutive Federal Open Market Committee meeting – an increase of a total of 500 bps over 16 months – has taken the Fed funds rate to the current 5.25 per cent to 5.50 per cent range.

This stands in contrast to the relatively gradual pace of hikes of a combined 200 bps (or 25 bps over nine increments) in the three years post-global financial crisis, from December 2015 to December 2018.

Even though inflation and jobs data this year has been a tug-of-war between inflationary and recessionary readings, recent data in June and July suggests that the rate hikes designed to cool inflation have worked as we witness signs of disinflation (or a fall in the inflation rate) from the lower Consumer Price Index data.

At the Bank of Singapore, we believe that the Fed’s 25 bps rate hike in July is its final one for the year as inflation eases. However, we expect the central bank to leave Fed funds rate elevated at 5.25 per cent to 5.50 per cent to keep inflation at bay, and potentially induce a US recession that may bring inflation back to its 2 per cent goal.

Though this year’s second-quarter gross domestic product growth beat forecasts, the US economy will likely slow further as the full impact of the Fed’s aggressive rate hikes may weaken activity over the next few quarters. Our base case is for two consecutive quarters of US economic contraction starting from Q4 2023.

Equity markets have staged a strong recovery year to date amid expectations of disinflation, moderate jobs and wage growth accompanied by mild economic growth to achieve the sweet spot “Goldilocks” scenario of a soft landing, or an economy that is “not too hot and not too cold”.

Yet, for most individual investors, economic uncertainty, interest-rate volatility and gyrations in capital markets over the past 12 to 18 months have prompted a level of caution. Recent surveys show that many investors have increased allocation to cash and cash equivalents in their portfolios this year.

Higher deposit rates not only raised the opportunity costs of investment, but also offered predictable investment outcomes compared with the variability of equity and bond markets.

However, this inflection point in the interest-rate cycle may foreshadow the reinvestment risk arising from cash and cash equivalents, as prevailing rates or yields when deposits mature may not be as attractive in six to 12 months.

Longer-term investors might want to reassess the current opportunities across asset classes, such as bonds, equities and alternatives. This may be an opportune time to rebalance portfolios to adjust to expected market conditions.

What does this mean for investors?

Currencies

The US dollar is expected to weaken in the medium term as the Fed’s rate-hike cycle ends and the disinflation trend balances off the resilience of the US economy. On the other hand, we think the view that the US dollar’s dominance is being eroded is overstated, as the currency is still the pre-eminent mode of exchange for global funding, trade, payments and cross-border loans.

While the US dollar share of US$12 trillion of global reserves has declined gradually, it still makes up 59 per cent of global reserves, that is, nearly twice the combined value of the euro, pound, yen and renminbi.

US interest rates and fixed income

Despite the recent spike in 10-year US Treasury (UST) yields above 4 per cent, we forecast UST yields to fall over the next 12 months to 3.25 per cent as growth weakens.

Recent interest volatility resulted from a combination of an untimely downgrade by rating agency Fitch of US’ sovereign rating from AAA to AA+, increased UST issuance and uncertainty in the government bond markets after Bank of Japan widened its yield curve control monetary regime.

Our forecast for a US recession underpins our barbell strategy for duration in bond portfolios where investors can lock in attractive all-in yields at the front end, coupled with a longer duration strategy as we near the end of the rate-hike cycle.

This approach cushions the reinvestment risks posed by the front end, while hedging against the risk of any move higher at the longer end of the curve. Historical data suggests that longer duration consistently outperforms following the conclusion of rate hikes.

Equities

Although the US equity rally year to date was propelled by a concentration of stocks exposed to the generative artificial intelligence theme, we believe current valuations may have overreached the longer-term monetisation potential of large language models on businesses.

Instead, we prefer opportunities in relatively defensive sectors including utilities, consumer staples and healthcare. Our preferred region for equity outperformance is Japan and Asia ex-Japan, where central banks lean towards a dovish stance versus US and European peers. Japan’s listed companies are embarking on corporate reforms, while China will enact more counter-cyclical policies to support growth in selected industries and sectors.

Alternatives – private markets

The US private equity market generated positive, low-single-digit returns in Q1 this year and likely in Q2 as well, despite still-depressed levels of activities in aggregate.

While caution prevails for the rest of 2023, we are positive on the alpha that private markets can generate through the business cycle, even in a higher-rate environment. Private credit lenders have picked up market share to maintain resilient returns despite the sharp rise in base rates.

They have stepped into the space as banks and other institutional lenders retreated from high-yield, leveraged lending. While they offer flexibility in underwriting, private credit firms have also adjusted to macro risks by tightening their lending standards and terms. This unique positioning has drawn investors to the asset class.

For investors with long-term objectives, a well-diversified portfolio of cash, stocks, bonds, commodities and alternative investments, calibrated to investment objectives and risk tolerance, is the bedrock for building resilient portfolios.

The writer is chief investment officer and head of portfolio management and research office, Bank of Singapore