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The US Federal Reserve Bank continues to “turn the screw” on the global bond and equity markets. Forced to act by high inflation numbers they are undertaking the fastest and largest tightening of monetary policy in history. They claim to be unconcerned by the risk of recession or of any collateral damage to the financial system.
As each month passes, they have ratcheted up their “hawkish” rhetoric. 12 months ago these same Governors stated that interest rates would not go beyond 2.5% and that inflation was “transitory”.
Now they are forecasting rates of 4.5% and to remain at this level until inflation comes down.
The odd thing is that inflation is already coming down and thus this stance is being increasingly seen by the markets as punitive and excessive.
Our view remains that much of this is opportunistic, they have a window to get out of the excessive money printing of the post 2008/09 period and get interest rates from close to zero back to a normal 2.0-2.5% and end QE.
All very sensible, unless as we have highlighted as a major risk many times this year, they go too far. If they do, they will have created a set of circumstances when the Fed will have no choice but cut rates back to zero and start QE again!
The Fed is also at the root of the market’s response to the calamitous first mini-Budget from the new UK leadership. The Fed’s action means that the dollar is very strong and US Treasury Bonds are yielding c4%. The pound has been consequently weak and oddly Gilts were yielding less than their US equivalent.
Unsurprisingly, when it became clear that UK borrowing was likely to be way higher than previously indicated, Gilts had to reprice and are now at a modest yield premium to the US, which is where they traditionally should be.
But, as ever the big issue from the mini-Budget arose from an unintended consequence. It turned out that many company pension schemes were not funded by real financial assets but by derivatives and this required the Bank of England to support the market.
This is the danger when Central Banks squeeze the money supply, markets just don’t know what or how damaging these unknown consequences may be.
Central Banks Balance Sheets…..the Big Squeeze
The first chart shows the amount of money that has been “removed” from the global economy by the big 4 Central Banks, led of course by the Fed. What this chart shows is that the scale and speed of this contraction has been staggering.
The fact that a severe global recession hasn’t occurred is down to the financial cushion companies and households built up during Covid lockdowns and also most economies are at full employment.
The second chart shows the dollar. In times of difficulty money runs to the dollar but also doesn’t stay there for long. We are at/approaching extreme levels on both of these charts and there are many others like them.
When will they turn?
Normally, there is some kind of trigger that precipitates a reversal. Hard to say what this could be at present, what we need to be very aware of, is that this all the Fed’s decision, it Is not being forced on them by external forces such as the banking collapse in 2008, which is a significant difference. The Fed started this and the Fed will end it, either when they choose to do so, or are forced to, by the aforementioned unintended consequences.
The UK Mini-Budget
During the protracted Conservative Party leadership election campaign Liz Truss had consistently flagged that she would provide substantial funding to subsidise gas and electricity prices and would reverse Rishi Sunak’s National Insurance and Corporation tax increases that, with hindsight, turned out to have been badly timed.
Markets were just about ok with this. They recognised that borrowing would be needed to fund the income shortfall and given that the UK has one of the lowest debt to GDP ratios in the G7, it was affordable.
However, what actually arrived in the mini-Budget was 5 times as much in value of tax cuts than was previously indicated. What was worse is that there was no supporting evidence as justification.
This was like a company going to its bank manager asking for five times as much as previously indicated, having sacked the Finance Director and not bothering to provide a supporting Business Plan.
The market reaction was initially quick and savage but has since stabilised at reasonable levels. Much was made in the media of the collapse in the pound; year to date it is down 16% versus the mighty dollar, but then so is the euro which is down 13% and the yen by 20%.
Gilts suffered a sharp move, but this ended with the 5 year Gilt yielding 4% with the US equivalent at 3.8%, so about right. The Bank of England did have to step in to buy 30 year Gilts, due to pension fund derivative margin calls, but only by a miniscule amount.
This is an ongoing political story, however, from a market perspective, unless the OBR report is truly horrendous, it seems to have passed. The crucial, for the UK economy, mortgage market is nevertheless fragile following the news.
The key Gilt yields which the mortgage market feeds off (not Base rates) are the 2 year and the 5 year, these are both, as we write, yielding around 4%, whereas Base rate is at 2.25% and the US version is at 3.25% (hence the Bank of England is behind the curve).
Market expectations are thus for Base rates to rise by 1% at the next meeting in November or possibly earlier. UK mortgage rates are ultimately hostage to US interest rates and should, in theory, stabilise in the 4.5% to 5.5% range, as long as US rates remain around here.
Fear and Greed
Are we nearly there yet?
Bull markets can only resume after a period of excess “fear” and what is known as “capitulation” takes place i.e. when everything seems so bad that it would seem that share prices are never going up again!
Various fear and greed indicators are flashing buy signals and the above charts are typical of these. The first is US Consumer Sentiment, this chart form JP Morgan also helpfully highlights the 12 month return in the S&P 500 following a high or low.
The average 12 month return from a low is 24.9%. The second chart from Goldman Sachs takes an average of a wide range of sentiment indicators. There is room for it to fall further but it does highlight that “fear” is the dominant emotion, which from a future portfolio return perspective is good.
Markets
Markets go down on the fear of a recession, however, they go up when it arrives.
As we wait for the Fed to change its mind, markets are just starting to see hard evidence that a recession is finally occurring in the US. Both the Case Schiller and Black Knight indices showed that, in August, US home prices fell by the most since 2008.
Job openings are slowing and even the big tech firms are laying off contractors.
So we are getting there, it is now just a question of how long the Fed waits until it at least stops “turning the screw”.
Many commentators now think that the next US interest rate increase, to 4.0%, will be the last, hence US Treasury Bonds and thus Gilts are hovering around the 4.0% level.
October will also see the third quarter US corporate results season. The strength of the dollar will have an impact, also consumer facing companies will struggle.
The current market valuation is low, analysts are however, notoriously slow to adjust profit forecasts for recessions. This means that this season could be a very mixed one.
But then again we are in the strange situation where bad news in good news, as the faster the slow down, the quicker the Fed will reverse its tightening strategy.
For investors the key here is patience, we do feel the Fed still wants to engineer the traditional pre-election economic boom, that still gives it a six month window to get inflation under control. The last two inflation prints for both Consumer and Producer Prices were where the Fed would want them to be, a third means that there will be a trend.
If this does come to pass then ultimately the pressure on mortgage rates on both sides of the Atlantic, (US 5 year fixed mortgage rates are currently 5.3%) should ease slightly, though they are unlikely to go back to the pre-Covid levels. So for October we need to watch the economic data, as well as company profits, bearing in mind that bad news is good news.
October 2022
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This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
