24 November 2022
Major central banks have been single-minded in their fight to bring down runaway inflation, even in the face of slowing economic growth. But with every rate hike increasing the probability of a global downturn, and inflation showing signs of peaking in some countries, there’s been growing optimism that the biggest of these rate hikes could be behind us. Markets have been closely monitoring central bank communications – especially the US Federal Reserve’s – for hints of a “pivot”.
Could a central bank pivot really be on the horizon, and what does that mean for your investments?
A central bank is said to “pivot” when it changes its monetary policy stance. This could be a shift from monetary tightening (interest rate hikes) to monetary loosening (rate cuts) or vice versa.
Let’s start with the Fed. For a Fed pivot to actually happen, we’d need to see one of two things:
Inflation moving closer toward the central bank’s 2% target, or
a more significant weakening of the labour market.
Headline inflation decelerated to 7.7% year-on-year and 0.4% month-on-month in October, coming in lower than market expectations. Core inflation, which excludes volatile food and energy costs, also moderated to 6.3% year-on-year.
Markets celebrated this inflation reading, on hopes that:
The Fed could start to slow its pace of rate increases, and
It might not have to hike rates as much as expected.
While inflation is still well above the Fed’s 2% target, that it’s starting on a slowing trend is good news. There are also signs it could ease further: falling rents suggest that housing costs – which make up about a third of the CPI basket – could peak soon, bringing down overall inflation.
Also, the current trajectory of inflation maps well against previous spikes in inflation. If we take history as a guide – in particular, the average of previous spikes in inflation since 1940 – inflation is likely to move back down toward target.
Our key takeaway? Inflation will eventually subside. But our CIOs expect a bumpy ride towards normalisation.
A more pressing concern for the Fed might be the tightness of the US labour market. During the pandemic, American workers dropped out of the labour force for reasons ranging from health issues to early retirement. And as companies competed for workers amid a shrinking workforce, the resulting rapid wage growth contributed to higher inflation.
The jobs market is still looking very strong. The latest unemployment rate rose to 3.7% in October, but that’s still close to an all-time low and below the historical average of 5%. Importantly, it’s below estimates of the “natural rate of unemployment” (or the lowest rate before inflation starts to increase).
During US recessions over the past 75 years, the unemployment rate saw a median increase of 3.3 percentage points. But since the start of the year, unemployment has fallen by 0.3 percentage point – suggesting the labour market could still be a source of inflationary pressure.
The Fed projects unemployment to rise to 4.4% by the end of next year. But for that to happen, the economy needs to slow much more significantly.
The Fed has already done a lot of heavy lifting. As you can see in the chart below, it’s ratcheted up interest rates by 375 basis points in just 8 months – a relatively short period of time. And it takes time for interest rate hikes to work their way through the economy.
Recent comments from Fed officials suggest that while the latest inflation reading is encouraging and that it may be time to start easing off on the pace of rate hikes, it’s too early for the central bank to back off on its mission to tame inflation.
We believe the more important question, then, is how much further the Fed has to go, rather than how quickly rates will rise from here.
The latest signals from Fed Chair Jerome Powell suggest that the fed funds rate could go higher than its forecast in September (4.5%-4.75%) and stay there for longer.
Powell has said the central bank is looking to achieve a moderately positive real interest rate. (The real rate is the nominal interest rate minus inflation.) When real rates are positive, that means interest rates are high enough to slow nominal growth.
If markets expect inflation to fall to about 4% by the middle of next year, that means a fed funds rate of about 5% is consistent with that assessment. And how long the Fed would need to keep rates there would depend on the trajectory of inflation and unemployment.
Our key takeaway: The Fed is likely to slow its pace of rate hikes, but it’s also likely to bring interest rates higher than previously signaled. It could also keep rates elevated for longer to slow the economy.
Other major central banks have also moved aggressively to fight inflation with outsized rate increases similar to those of the Fed. But the drivers of inflation in the rest of the world are different, and so are their broader economic conditions.
In much of Europe, for example, supply disruptions – like those related to the Russia-Ukraine War – have been a key driver of inflation as they’ve cranked up food and energy costs. Asia, on the other hand, is also seeing some inflationary pressures due to rising demand from economic reopenings, as well as weaker currencies. (Read more here: What's Going On in Global Currency Markets?) But overall, inflation has been more manageable in the region compared with the US and Europe.
But weaker growth is of increasing concern for global central banks, especially those whose economies haven’t seen the same level of resilience as the US. Financial stability is another risk, especially for economies facing high household or corporate debt. In economies where variable rate mortgages are more common – for example, Hong Kong or Australia – that also means rising interest rates have a larger and quicker impact on housing markets.
In general, the combination of supply-driven inflation, slower growth, and growing risks to financial stability means that some global central banks may start taking their foot off the rate hike pedal sooner than the US.
In addition to interest rates, central banks can also use other tools to adjust monetary conditions. One of those is buying assets like government bonds to increase the money supply, lower interest rates, and stimulate economic activity (known as quantitative easing, or QE).
The flip side of that is selling those assets or letting them mature in order to decrease liquidity, increase interest rates, and cool the economy (known as quantitative tightening, or QT). And we’ve already started to see QT in action:
The Fed has already begun to reduce its balance sheet, which more than doubled from $4 trillion USD before the pandemic to a high of $8.9 trillion USD in April 2022.
The Bank of England also started to shrink its balance sheet in November, after postponing its plans due to the market turmoil of the past few months.
The European Central Bank is expected to join next year after it ends its interest rate hiking cycle.
We note that this contrasts with the situation in Asia, where manageable inflation is allowing its biggest central banks – the People’s Bank of China and the Bank of Japan – to keep monetary policy loose.
That means three of the world’s major central banks – the Fed, BOE, and ECB – will be removing liquidity from the financial system at a relatively rapid pace, putting further upward pressure on borrowing costs. Rising real interest rates also mean more downward pressure on asset prices, as:
the risk-free rate (i.e., bond yields) becomes more attractive, and
the cost of capital rises.
QT at this scale is relatively untested and the last time the Fed attempted it in 2017-19, we saw unexpected disruptions to credit markets. During that cycle, the Fed’s balance sheet reductions maxed out at $50 billion USD per month; this time around, the central bank’s maximum monthly reduction is nearly double that at $95 billion USD a month.
And although central banks are being very careful in communicating their plans and the Fed in particular has introduced measures to avoid the issues it faced the last time around, this could still open up the possibility for market volatility and uncover hidden weaknesses in the economy.
Short-duration and USD-denominated assets may continue to outperform in the near term as the Fed continues to hike rates – albeit at a slower pace – and potentially keep them elevated for longer. (Read more here: What US Dollar Strength Means for Your Investments)
For equity markets, even though inflation is starting to come down and the Fed is likely to slow its rate hikes, it’s still too early to say that the current rally is the beginning of a bull market. As the economy slows, companies may struggle with earnings downgrades, which could weigh on share prices.
However, as inflation peaks, bonds may start to recover from their historic rout as we get closer to the end of the rate hike cycle.
So, with markets expected to remain volatile as they hang onto every central bank decision, we continue to recommend investing regularly into a diversified portfolio. Ensuring you have broad market exposure, at a risk level that you’re comfortable with, smooths out your returns over the long term so you can have peace of mind even if markets are volatile in the short term.
And while we can’t avoid short-term volatility, we can take steps to prepare for it. In short, keep enough cash to cover your immediate expenses, avoid racking up unnecessary credit card debt, and build an emergency fund so you have a safety net for any unexpected spending needs.