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The Big Conversation

Episode 118: More interest rate hikes from the fed?

This week Roger Hirst looks at the onset of the rate hiking cycle and the additional re-pricing that has taken place since the first hike. Yield curves are inverting, but should we follow the usual sequencing of the last 30 years? Inflation may make the gap from inversion to recession much shorter this time around. In the Chatter, Kiran Ganesh of UBS Wealth Management outlines the prospects for rates and a few diversification strategies.

  • Roger [00:00:00] On Tuesday, the US 2-year, 10-year yield curve briefly inverted by just a few basis points, whilst the 5 year, 30 year portion has inverted for the first time since 2006. The Fed, however, still appears to have a lot of tightening to do if financial conditions are to tip the economy into recession. But could inflation force them to tighten at an even faster pace than is currently expected? That's The Big Conversation.

    Roger [00:00:29] The good news is that the most commonly quoted part of the curve, the 2-year, 10-year portion, is still extremely early in the sequencing that leads to recession. Now, just to recap, since the mid-1980s, the yield curve has first inverted, then reached its deepest, almost negative point within the inversion and then started to re-steepen before recession takes place. And this is a process that can take many months and even years, from the first inversion to an actual recession. This sequencing took place before the 1991 recession, the 2001 recession and the 2008 Great Financial Crisis. It even took place before the pandemic-induced recession of 2020, though the inverted yield curve was in no way predicting a pandemic on that occasion. So although the yield curve has just touched an inversion, the sequencing suggests we're still many months away from a recession. But that classic pattern of the last 30 years could be misleading today. Those periods saw business cycles where the Fed's tightening basically shadowed the pickup in growth. Inflation was largely a consequence of that growth in those periods. Today's inflation is significantly in excess of current growth, and that has the potential to be demand destructive. Every spike in inflation since the early 1970s, except for the one in the late 1990s, took place within the depths of a recession. Either today's spike in inflation is going to be the first that doesn't have an impact on growth, or inflation is a long way from topping out, or it could be both. But the historical pattern suggests that inflation may be an accelerant for recessionary events. And furthermore, we can see that the last time we had inflation at similar levels to today, back in the early 1980s, the yield curve was actually falling into the recessionary event. There was no re-steepening before the recession, and although today's curve has only just marginally inverted, it is following a similar path lower. Real wages and real disposable income are under a lot of pressure today. And many households could soon be in recession, even though total household wealth when housing and equity markets are added together, has reached new highs in the US. In the UK, The Office for Budget Responsibility recently suggested that UK living standards which is disposable income adjusted for inflation, could see the largest fall since records began in 1956. And whilst that's not a real recession in terms of GDP, for many consumers, it will feel like one. And then we also have to factor in the response of the Fed and markets. Currently, the Fed are well behind the curve. The Fed's target rate, currently in the 25 to 50 basis point band, looks very underwhelming compared to the US headline CPI nearing 8%. The Fed has already increased its own forecast for rate hikes in 2022. Three were expected in December 2021, and this increased to seven from the March 2022 meeting through to the end of the year. But already, many in the market are anticipating that this will not be enough. And some analysts are predicting four more 50 basis point hikes in 2022. And if you've been used to a 3% mortgage, that now rises to 4.5% well, that 1.5 % rise has much more impact than a similar rise, from 10% to 11.5% in the past. The year-on-year percentage change in the Freddie Mac 30 year fixed rate mortgage is towards the highest level in 20 years. Furthermore, the Fed is tightening into a market that's already shown a lot of signs of uncertainty. So something will probably have to give. We can see some of this unusual pricing in the volatility markets. Bond volatility using the MOVE Index has been moving significantly higher towards recessionary levels even as the VIX index on equities has plummeted. FX volatility has also been moving higher. Dollar Yen is of particular note. The Bank of Japan announced that it will lock 10-year yields at 25 basis points, with yields screaming higher in other regions. Japanese investors are moving into overseas assets. The Yen has now broken out of another significant reversal pattern in the last few days. But before we get too carried away, some of this might just be connected to rebalancing into Japan's financial year-end, which is the 31st of March. But Kuroda gave the green light for domestic investors to pursue overseas alternatives a number of weeks ago, when he indicated that the Bank of Japan will be prepared to suppress yields indefinitely. So unusual activity in major currency markets is often a sign that the sands are starting to shift. The Bank of Japan can't control yields and control the currency - one will have to give. Even if today's global inflation is a one-off bottleneck, it will still take time to work its way through the economy. And if it persists, it will inevitably become a significant drag on growth. So although it feels the Fed is still got a lot of tightening to do, some investors are now placing contrarian bets that the hiking cycle will not be completed as currently forecast. One potential hedge to a slowdown has been to buy calls on the Eurodollar future. The June 2023 contract is that the low point of the curve, and has been implying a funding rate in excess of 3.25%. If a rapid hike this year causes a market wobble, we may never see these levels and we might just get a bounce in the Eurodollar futures from some of these extreme readings. And that unknown element of current inflation means that it is better to use options rather than risk trying to catch the falling knife in futures. It may also be the time to look at equity index puts once more. Markets have had a healthy rebound to some key retracement levels, and having recently approached 40, the VIX has dipped back under 20. The divergence from bond volatility is unlikely to persist. Bond volatility has a long way to fall, or it may be that equity volatility has a long way to rise. It certainly looks relatively mispriced, with equities implying a benign outlook, whilst bonds and currencies have recently been acting as though there are a few bumps lurking on the horizon. That said, most expectations are that the yield curve is still well short of flagging a recession. Kiran Ganesh of UBS Wealth Management explains their thinking on rates and how to navigate this environment with a diversified portfolio.

    Roger [00:06:24] KIran, welcome, thanks very much for joining us. And I'd love to get your thoughts, UBS's thoughts on, first of all, what's probably the most important bit for the markets at the moment, which is; where are rates going, US rates are going, so at the front and what expectations there have been, but also what's happening at the back end of the curve as well? So the 10-year space, because we're starting to see now these inversions across pretty much the whole space. So could you just give us some of your thoughts on what, what to expect there?

    Kiran [00:06:49] Yeah. Well, I think it's actually probably quite important to start at the back end of the yield curve because that gives you something of an anchoring point as to where you think the short end is going to go. We think that the back end of the curve will top out at around 2.5%, so not too much higher than we are today. And that's because we believe that the neutral rate is still in real terms between 0 and 0.5%.  And then if you add inflation of 2% in the medium term, on to that, you get to about 2.5. So that's your kind of long-term anchor. Then of course, as you said, the big question is, well, where do we get to in the near term? I think the Fed is acknowledging that it is behind the curve, so it is likely going to have to tighten beyond that long-term rate over the course of the next couple of years. So we think that the 2-year yield will hit around 2.75 by the end of this year and reflecting that need to tighten policy maybe a bit beyond neutral in order to contain inflation. You know the way they get there; we think it would probably be a 50 basis point hikes a couple of times, and they're likely to frontload that and hike for the remainder of 2022 and then slow down the pace of hiking in 2023 as they start to get more data and hopefully some signs that inflation is coming under control.

    Roger [00:08:04] And so potentially we might get this , this vaunted inversion of the yield curve, which is really a countdown to recession but is not always a countdown to recession. What's the thinking there? I mean, if we do get an inversion, inversions don't cause recessions, but do you think if we got an inversion more than we've just had, you know, a proper inversion? Do you think that that is a count down to a potential recession? Or do you think that this time we can look through that?

    Kiran [00:08:27] Well, it is factually correct that following inversions in the past there have been recessions, but I don't think it's fair to say that inversions have always caused recessions, and I think we can take, you know, Coronavirus as an example, look the curve did invert and there was a recession subsequently, but they weren't correlated at all. The recession was due to the pandemic. The other thing we would note is that the recessions have tended to come with a lag of between 1 and 3 years, and what happens in that first year for investors is also quite important, so what we have seen is that equity markets have tended to rise after an inversion and have only started to fall when the economy peaks and when you actually get into that recession. So while an inversion historically has ultimately ended in recession, we don't think that investors should try and anticipate that, we think it's best to stay invested, and then obviously when we do start to see signs that the economy itself is slowing, then maybe that's the time to reconsider equity investments.

    Roger [00:09:29] And so I guess the key question for customers, for investors then is, within this sort of environment of a rate hiking cycle, higher rates and inflation, what sort of equity mix should people be thinking about?

    Kiran [00:09:39] The typical beneficiaries in a rising rate environment are financials and value. Those are two of our preferred parts of the market at the moment. Financials tend to do relatively well, especially if rates are being hiked quite quickly, because then they won't necessarily pass on all of those increased interest rates on to, on to depositors, and then they can make a reasonably healthy interest margin in the meantime. Of course, the flatter curve is a challenge, shall we say that's more of a tactical call on financials, and then if you look in the value space generally, we think that that should outperform growth. And because if you do start to have higher interest rates, then people are going to be shifting away from some of those profitless tech companies, companies where maybe the profits are going to only come in 5 or 10 years time and prefer to be in companies which are paying perhaps higher dividends in the near-term and delivering higher cash flows in the near term. So we say that would be the two, two main paths to stay invested, but tilt a bit more towards those parts of the market.

    Roger [00:10:40] And should people also position for, you know, we were seeing these commodity prices, which is obviously there's a lot of uncertainty around them. But then there are some big megatrends such as, you know, green technologies. Should people be looking at some of the sort of energy sectors and the commodity sectors as well as a mix within there?

    Kiran [00:10:54] Yes. So we think in the near term that energy and commodities are quite an effective hedge for portfolios. Because if you think about some of the downside scenarios in markets and at the moment, then you would probably see energy and commodities outperforming in some of those downside scenarios, so we think it is an effective hedge for portfolios today. And then if we think longer-term and we do think that this theme of energy security and domestic energy production is going to become more prevalent in the years ahead, and that should favour sectors like green tech, sectors like renewables, as this becomes a more important part of different countries energy strategies.

    Roger [00:11:30] And in terms of, you know, people shouldn't have all their eggs in one basket, not too much concentration, for diversification, often uncorrelated has been places like China. China's had a pretty relatively torrid you know, year, year and a bit with a lot of volatility even recently. But do you see China as being a valid diversifier for an international equity portfolio?

    Kiran [00:11:49] Yes. Well, it has been a diversifier, and I think the big question is whether it's now going to become the good kind of diversifier, because of course, most investors don't like diversifiers which fall when everything else is rising, which has been the case for China over the past 18 months or so. We think that going forward now is a good time to be invested in China and for a few reasons; the valuations are low and it's one of the few markets globally where you're seeing the central bank cutting interest rates. Remember they're trying to achieve this 5.5 percent growth target against the backdrop of COVID 19 restrictions. So we think that that's going to mean relatively high levels of monetary and fiscal support, and we have had signs that some of the regulatory effects are coming to an end. You've had the vice-premier talking about a much more open attitude to technology and overseas investment, and we think that should start to support the Chinese market going forward. And from a diversification point of view, we've seen lots of the developed markets getting increasingly correlated. So US equities, European equities the correlations are now pretty high between those. So China is one of the few international markets which now has a lower correlation to the rest of the world.

    Roger [00:13:03] And then finally, we've talked mainly there about equities. But in this current environment, are there other things that people should be looking at or thinking about as ways of, you know, investing in this high rate, high inflation environment that's outside of the equities sphere?

    Kiran [00:13:14] Yes, well we, we've touched on commodities and we would say that within fixed income, we would focus a bit on senior loans so things which have got a floating rate structure because again, we think that's going to be preferable in this environment of rising rates. In currencies, we like the British pound and the US dollar; so two currencies where we're seeing quite significant interest rate increases over the course of the next year. We think that they should outperform some of the currencies where you're not going to see so many interest rate increases. And then in the alternative space, we think things like hedge funds can be effective diversifiers at a time when you've got bonds and equities and perhaps moving together because of some of those concerns about monetary policy. So we certainly advocate that approach of thinking in multi- asset terms and investing across equities, commodities, currencies, fixed income and alternatives.

    [00:14:03] So basically if we could summarise it up, which would be in this environment yes, there might be some uncertainty in the environment, but also there are some very clear trends, such as hike, rate hiking cycles and actually there are some very clear opportunities within that. So basic diversification but staying invested and benefiting from some of these trends is the best way to play it?

    Kiran [00:14:19] Yes, absolutely. I mean, there's a lot of uncertainty out there today, but there are trends where we can have a higher degree of certainty, whether it's around rate hikes, whether it's around this age of security that we're talking about moving into over the course of the next few years. We certainly think there are some trends which are relatively predictable and investable.

    Roger [00:14:40] Well, thank you very much for your time, Kiran, good to speak to you, and we'll hopefully hear from you again later.

    Kiran [00:14:44] Thanks Roger.

    Roger [00:14:45] So rate hiking cycles can provide a lot of opportunity for investors, and there are a number of super-cycles that should allow investors to ride out this current volatility. But perhaps the key word, however, is diversification in order to mitigate some of the regional and inflationary risks that exist today. If you have any questions about this episode, the economy or financial markets, please put them in the comment section or send them to fmt@lseg.com