Inflation has hit 30-year highs in the U.S. As the Federal Reserve takes steps to reduce liquidity and get inflation back close to the 2 percent target, we explore the impact on the wider market, including equities, bonds, house prices and oil.
- To gain control of inflation in the U.S., the Fed is undertaking a programme of interest rate rises, which will continue into the first six months of 2023.
- U.S. equities are now considered to be verging on being expensive, and real estate is at risk of a downturn.
- In the last month, the strength of the U.S. dollar has waned against other currencies, including the euro. Meanwhile, the price of oil remains volatile.
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After spending over a decade trying to create inflation the Fed this past year suffered from the curse of getting its wish with U.S. inflation surging to 30-year highs and well above the 2 percent target.
The Fed has been forced to do a U-turn and clamp down on liquidity to put the inflation genii back in the bottle.
As shown in Figure 1, Fed tightening of monetary conditions sent Fed funds soaring from near-zero at the start of the year to 3.75 percent, the highest level since the 2008 Financial Crisis.
The market is priced for the rising rate trend to continue into the first half of 2023, the six-month Fed futures contract prices the Fed Funds rate around 5.0 percent or roughly two more hikes at the Fed’s 75 basis point recent pace (or maybe three hikes as Fed Chair Powell indicated the pace may moderate going forward).
But the market already has an end in sight as the December 2023 futures market suggests rates will peak by mid-year with potential for some easing emerging in the back half of 2023.
Is U.S. inflation stabilising?
As is also shown in the chart, CPI year-over-year inflation has stabilised in a 6.0-6.5 percent range, which is well above where Fed funds are expected to peak. It would be atypical for the Fed to end a tightening phase with real rates still in negative territory.
Housing prices are showing signs of already having peaked, which creates prospects for moderation of inflation in the months ahead. Labour costs, however, are still pushing higher and as discussed in the October Market Voice, the monthly payroll gains need to drop from November’s 263K gain below 200K to see labour cost pressure ease.
With these competing trends, it seems unlikely that inflation will come off rapidly, so the market priced-in scenario has Fed funds peaking in negative or, at best, marginally positive territory.
While it is possible market expectations will be met and Fed funds will peak around mid-year at around 5 percent, it seems the risk is skewed that the Fed will hike more and longer than is currently priced in – indeed, the market has generally underestimated the potential for rate hikes since late last year.
In any event, the 10-year rate is on the cusp of inverting versus current Fed funds, so long-term rates are unlikely to reverse substantially in 2023. Indeed, it is probably not a coincidence that the priced-in Fed funds peak is roughly the same level they peaked ahead of the Financial Crisis and the 10-year rate was trading in line with Fed funds at the 2007 peak.
The only plausible scenario for a major bond rally in the second half of the year is if the economy goes into a deep recession, renewing fears of deflation.
Figure 1: CPI inflation, the 10Y Treasury Rate and futures implied outlook for Fed funds
Equities are no longer cheap and verging on expensive
A theme in this publication for several years is that while equity valuation – measured by either price/earnings or dividend yield – was expensive by historical standards it was not expensive relative to alternatives.
Selling equities due to overvaluation only makes sense if there are better-valued alternatives.
For fixed income, the traditional alternative to equities, the answer to this question has generally been there was little motivation to switch.
Before the pandemic, the equity dividend yield was on average modestly – 16 bps – lower than the 10-year Treasury bond yield and more significantly lower – 88bps – than AAA corporate bonds, making equities marginally expensive from a historical perspective.
In the early 2020 COVID-19 panic stock-market selling, the dividend yield moved to an unprecedented positive spread to both benchmark yields, taking equities to historic cheapness relative to bonds. The spread then mean-converged into 2021 reflecting a 30 bps drop in dividend yield and a 60 bps rise in bond yields.
As 2022 opened, the spreads were back to the modestly expensive pre-pandemic level.
Although the decline in equity prices in 2022 buoyed dividend yield, this was outpaced by the severe drop in bond prices – i.e., rise in bond yields – and dividend yields are approaching decade lows relative to Treasury and corporate yields.
History suggests that equities can remain “expensive” for several years, so this is not an adequate basis to project a dramatic re-pricing of equities, but it is a powerful indicator that 2023 is very unlikely to see new highs in major equity indices.
Of course, a massive rally in bonds could re-establish equity relative value but, as noted above, this is only likely if the economy is experiencing a major contraction which would not likely be a backdrop for a bull market.
Figure 2: SPX dividend yield vs 10Y U.S. Treasury and AAA corporate bond rates
What about real estate?
While the real estate market has softened in recent months, prices generally remain well above pre-pandemic levels, suggesting that this market is also at risk of a major downturn.
In part, the price gain was blamed on a COVID-19 driven relocation of households to less dense regions and – as is true in so many markets – a lack of supply. While the price gains have been relatively strong in suburban communities and smaller cities, major city housing prices have also gained, suggesting this could be an indirect by-product of the overvaluation of other asset markets, as well as the still low real rate of interest.
Nevertheless, there is less evidence that real estate prices are overvalued or unsustainable. The blue line in Figure 3 shows the total value of commercial and residential land in the U.S. relative to the S&P index.
The line has risen this year showing that real estate gains have outpaced equity markets, but the surge still leaves the ratio well below historic levels.
Perhaps more importantly, the cost of household-related debt servicing also remains historically low relative to disposable income. While higher bond yields – and thus mortgage rates – could continue to cool off the real estate market, a significant decline in prices looks unlikely in 2023.
Figure 3: Is the real estate market overpriced?
Has the dollar peaked?
The first chart in Figure 4 shows the JP Morgan broad real (PPI-adjusted) trade-weighted dollar exchange rate.
There is a long history of the dollar’s general performance having ties to the yield curve with a flatter curve generally dollar bullish. Consistent with this, the curve flattening in 2021 was accompanied by dollar strength and the trend continued through much of 2022 as the 2 vs 10 curve moved towards inversion.
Over the past month, however, the two series de-linked with the curve moving to a new wide 75 bps inversion, but the dollar trend turning lower. It could be the dollar’s upside is being limited by the extreme real valuation and implicit loss of competitiveness in the global market. Indeed, the U.S. current account in the second quarter widened to its widest deficit – 4.6 percent of GDP – since the financial crisis.
The second chart in Figure 4 shows the USD performance specifically against Euro and suggests expectations on interest rates may also be a factor.
As noted above, the market expects Fed tightening to peak in the first half of next year so with other central banks – especially the ECB – just getting started on rate hikes the spread between 2-year EUR vs USD deposit rates has narrowed about 100 basis points in the past month and this appears to be a significant factor in the timing of the dollar turn.
If, as we suspect, the markets are underestimating the potential for Fed rate hikes next year, this creates the potential for a resurgent dollar as this becomes apparent to the market. But the extreme real valuation of the dollar should make it difficult for it to move much above this year’s highs.
Figure 4: U.S. yield curve and the real trade-weighted dollar
Figure 5: U.S. 10Y bond rate and S&P (SPY) performance versus emerging markets (EEM)
Emerging markets pricing in the Goldilocks ideal
In the first chart in Figure 5, the U.S. stock market (SPY), while volatile, on balance outperformed emerging market equities (EEM) into the fourth quarter of this year.
The relative performance of the U.S. market has generally tracked the 10-year Treasury bond rate, but with a higher bond rate associated with a stronger equity market. The rising trend in bond rates was driven by expectations that strong growth and rising inflation would lead to further Fed tightening.
The prospects for growth have outweighed the negative of higher rates, allowing the U.S. market to outperform. The shift to the outperformance of emerging markets this past month as bond yields peaked suggests anticipation that the Fed is going to get monetary policy “just right”: high enough to slow growth and contain inflation, but not so high that it triggers a deep recession and plunging commodity prices.
The prospects of more Fed hikes than expected – and the resulting higher risk of a deep recession – is likely to renew the earlier trend of U.S. market outperformance (even if the U.S. market is in decline).
And what about crude oil prices?
Given the political crosswinds of the war in Ukraine and implications for Russian crude oil exports (and at what price), the outlook remains highly uncertain.
That said, Figure 6 does suggest some basis for avoiding a sharp run-up in oil prices in the months ahead.
The OPEC cut in production – including Saudi Arabia – that was reported earlier this year is reflected in the 3.3 percent downturn in output during the third quarter. Prices, nevertheless, at just over USD81/barrel are well below the USD100 plus surge in the immediate wake of the Ukraine incursion. The price seems to have stabilised at around the USD80 level suggesting there is a rough equilibrium in the market.
However, at least to some degree, the stability is a by-product of withdrawals from the U.S. strategic petroleum reserve. With reserves now at the lowest levels in 20 years, it is not clear how much longer withdrawals can continue, providing a risk of firmer prices in the months ahead.
A pending proposal of an international price cap on Russian oil is also a potential market disrupter. And several other factors point in the direction of lower prices: higher interest rates, slower growth and the secular trend away from the use of fossil fuels.
This creates a very complex picture further muddled by uncertainty on winter temperatures and the resulting demand for heating oil. It seems the only sensible call is for a volatile market but ultimately with a flat trend at least into the second half of next year.
Figure 6: Crude oil price and Saudi output relative to OPEC total (monthly closes)
