We think this sort of commitment shows flagrant disregard to the collateral damage that may ensue. We have had 225bps of rate hikes over the last three Fed meetings and 300bps this year: this is a huge increase in a short period, especially as the impact is only fully digested 12-18 months down the line. At the time of writing, markets expect the Fed to deliver at least another 120bps of hikes, capping out at 4.6% early next year. Real interest rates, or the yield on a bond after accounting for inflation expectations as priced by the market, have also increased significantly.
We think that posterity will view this period of central bank policy as a series of terrible mistakes. Inflation has been more stubborn than many investors – including us – expected, but it is clearly slowing. Global recession is certain. Central banks and governments have achieved an enormous amount of tightening already: over 300 rate hikes across the world since Q1 2021, reductions in fiscal spending, a much stronger dollar (the broad dollar basket is now at levels we last saw briefly in the early 2000s, and before that in the early 80s) tightening financial conditions, and huge wealth destruction from falling equity and bond markets across the world. Tightening policy further from here through rate hikes and tapering will cause an unnecessarily deep and painful global recession.
Why then is the Fed so hawkish? It is too afraid of inflation, in our view. We also believe that Chairman Jerome Powell is concerned about repeating the mistakes of the Fed in the early 1970s, when they failed to stamp out inflation. That is not to downplay the price rises we have seen this year, which have had a very material impact on families, consumers and companies. We have seen higher food bills, galloping commodity prices – especially natural gas, which is a huge problem in Europe. However, the factors that have been driving inflation are not structural and are already starting to fade.
In 2021, the key driver of inflation was post-Covid supply chain problems. Those have subsided. This year, the driver was war in a crucial region (Ukraine/Russia) for agriculture and energy. Natural gas prices have more than doubled this year, and at its peak oil rose by just under 50%. Throughout the period, we have seen post-Covid disruption to the labour force further increasing costs on companies. Those higher input costs – energy, labour, food – have fed into prices across the globe.
Inflation may take some time to come down. Year on year numbers are still affected by base effects. The most recent CPI print was higher than forecast. Much of that upside surprise was caused by shelter (housing/rent), which makes up around 30% of core-US inflation, and in particular owner-equivalent rent (OER). Shelter inflation is “smoothed” and is sticky. US housing is slowing significantly, because higher mortgage rates and higher prices have pushed housing affordability to levels we have not seen since before the global financial crisis. OER will come down in due course. It is also worth noting that we have not yet seen lower commodity prices translate fully into lower prices at the pump or in shops.
The reasons to hope that global economic growth can be sustained are backward looking and not supported by current data. While jobs numbers in the US have been robust, we are also seeing people taking second jobs to cope with higher costs. Forward-looking indicators look truly terrible. Over 40% of countries’ Purchasing Managers’ Index (PMI) data is under 50, indicating contraction in economic activity. Looking at new orders data, which leads PMIs, the percentage of countries showing contraction jumps to over 70%; this suggests further weakness ahead. We mentioned earlier the collapse in shipping rates, and housing: monthly US mortgage applications have fallen to their lowest levels since 2015. And where US housing goes, so goes employment and broader growth.
The chart below shows the relationship between housing sentiment and the labour market in the US. Housing is also weakening in Australia, Canada, South Korea, Sweden, and many other countries. Over the last 75 years, when the unemployment rate has risen more than 0.5% there has been a recession. Whilst the cost-of-living crisis is hugely damaging, a looming recession with rising unemployment is far more devastating.
Where housing goes employment follows
This year has been one of the most difficult we are likely ever to see in fixed income given the leap in rates and widening spreads. As we head towards the fourth quarter, bond yields are telling us that inflation will keep the Fed tightening, and equity markets are indicating a relatively soft landing. Our analysis provides a different perspective.
There is a significant lag between action and effect in monetary policy: the Fed and other central banks have already tightened more than enough to slow inflation and cause a recession, but they continue to tighten because the impact of what they have already done has not come through yet. Critically, as this chain of events unfolds, it will re-introduce the negative correlation between government bonds and risk assets that has been absent from markets for the last 12 months.
Sources for all data are Bloomberg, as at 23 September 2022
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