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The Federal Reserve is still trying to gain control of the inflation narrative on Wall Street but far more importantly on Main Street. It is yet to fully succeed, but likely will prevail by front loading tightening, signaling a likely series of 50 basis point rate hikes ahead of us roughly as expected by the market.
The Fed uses two tools to impress Main Street:
- An expected rapid set of interest rate increases that are yet to have an impact on surging real estate prices but are affecting first-time and low income buyers. Other buyers are flushed with equity gains post Lehman crisis while the housing supply has not been able to keep up with. One should note that according to Redfin bidding wars for housing have slowed down after 6 months of accelerating suggesting that higher interest rates are making buyers more prudent.
- The Fed’s proposed balance sheet reduction is impressive. However, a quick look at the resilience of Bitcoin and its QE infinity mantra reveals that it does not convince Tech savvy households. In addition, Megacap Tech has somewhat deflated but remains very expensive, e.g. Tesla.
To gain back control of the narrative, the Fed may well front load rate hikes somewhat more than expected and a rundown faster its balance sheet, particularly in its long-dated bonds book. Larger rate hikes initially don’t change the end point of the rate hiking cycle, but it does leave the Fed with a conundrum: Can the Fed surprise the market without sending equities into a vicious negative feedback loop and the US economy into a rapid economic slowdown? Most likely yes, and it should be helped by inflation having temporarily peaked on the back of more subdued energy prices and some improvements in the supply chain.
The danger of a recession
The danger of getting it wrong is significant but small. The US equity market is expensive, debt has built up post 2010 (see Graph below) and much of the equity market is expensive. While leverage ratios are sound as a whole, a poorly managed Fed operation would have a considerable negative impact on US credit and equity. Indeed, talk of overtightening, as often happened in past business cycles, has led part of the market to expect a recession. This view has been reinforced by the telling inversion in the US Treasury curve. However, Bloomberg consensus expects only a 25% probability of a recession led by a deep skew of a few economists making very aggressive calls. Remove them and the odds are actually quite subdued. Goldman Sachs which doesn’t report to Bloomberg has an odd of 15% next twelve months and 35% next 24 months. In other words, the market is unsure if the Fed can control inflation without killing growth, but economists are hopeful.
Economists tend to view growth as something rigid and fairly predictable when in reality it is like walking through an English garden, full of hills, sunken lanes and trees that block the view. That means the ability of the Fed to signal and control the narrative is paramount which suggests preponing the cycle of rate hike. There are two objectives: 1. Controlling household expectations, and 2. Controlling corporate expectations, especially avoiding that corporates react poorly to a surge in wage and borrowing costs by expecting a rapid economic slowdown. The process of reaching to CEO for the Beige book will therefore be crucial. For now, earnings growth at 7% suggest corporates are confident about US consumers and their ability to raise prices. Eventually though, employees in mature sector – namely the old economy – should start to react poorly especially among low income (e.g. leisure industry).
The peak of inflation
Deutsche Bank claimed on the 19th we had seen the peak in inflation after strong demand hit strained supply chains. The latest print was helped by weaker car and truck prices after prices probably overshot the mark. The problem is that second round effects have already started and as a stone triggers an avalanche, the process has started reinforced by a tight labor market and high savings (cash/equity..). These are dynamics that are actually very hard to forecast. Furthermore, supply chain shocks are still ahead of us with lockdowns in Shanghai that are spreading. The net outcome depends in part on the Fed’s ability to control the narrative and to slowdown the economy. Both might take months to be won.
Eventually, the back-end of the US Treasury curve will have risen enough with waning momentum to attract many older households looking for refuge from an expensive US fixed income market. As we eventually peak ESG Investment Grade and Fixed Income should be in strong demand. Till then with such a still uncertain outlook, the opportunity set for managed fixed income should continue to be large.
Non-financial debt has been on a sharp increase since 2011, but leverage dropped as equities surged.