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The relentless March of rates

Interest rates are on an upward march almost everywhere. 23 central banks have raised rates so far in March, notably including the US Federal Reserve and the South African Reserve Bank. Also noteworthy was the 150 basis points hike that took Brazilian short rates to 11.75%. They were only 2% a year ago.

Aiming for a soft landing

A Federal Reserve (Fed) rate increase in March had been on the cards for some time and did not come as a surprise. What is notable, however, is how the tone of Fed officials have changed, particularly that of its Chair, Jerome Powell. In a speech last week, Powell noted that inflation in the US (now running at almost 8%) was “much too high” and that the Fed has to move “expeditiously” to remove stimulus measures and ultimately move its policy stance into restrictive territory.

The so-called dot plot summarising the forecasts of Fed officials now points to interest rate increases to 2.4% by the end of next year.

Powell also noted the strength of the US economy and in particular the labour market. Unemployment fell much quicker than expected after the first Covid shock and there are now more job openings than unemployed people in the US.

The Fed is aiming for a “soft landing” by trying to contain inflationary pressures without triggering a recession. Powell noted that this should be possible given the currently low unemployment rate.

The Fed has achieved soft landings in some of its previous hiking cycles, but there are also cycles where it went too far and triggered a recession. Indeed, in the early 1980s, the recessions were arguably deliberate to break the back of entrenched inflation.

Today’s much higher debt levels and much more financialised economy means the pain point is probably lower than in the past, but no one knows exactly where it is. In the most recent cycle, the fed funds rate reached only 2.25% before credit and equity markets showed signs of severe strain and the Fed changed course. This came to be known as the Powell Pivot.

By placing far greater emphasis on inflation, Powell has now pivoted again. He and his colleagues are likely to carefully monitor incoming data to gauge the impact of their actions and external events like the war in Ukraine. The big question is what they will do when forced to choose between fighting inflation or supporting growth. It seems that they are now likely to focus on inflation, even if there are risks to the growth outlook.

This suggests the famous “Fed put,” the real or imagined tendency of the Fed to come to investors’ rescue first associated with Alan Greenspan, is no more.

Bonds battered

Rising interest rate expectations has hammered bond investors this year. The FTSE World Government Bond Index has suffered an equity-like drawdown of 12% in 2022 in dollar terms as prices fell and yields rose. Bond returns are the combination of interest payments (coupons) and price changes. Since yields were so low to begin with, investors had little cushion from interest payments and were heavily exposed to price declines.

The benchmark US 10-year government bond yield was only 1.5% at the start of the year and has now zoomed up to 2.3%. Shorter-dated bonds, like the 2-year Treasury note is even more exposed to expectations of Fed hikes and has surged higher from 0.7% to 2.1% this year.

The gap between short- and long-dated bonds – sometimes called the yield curve or the term structure – has therefore been narrowing. When short-dated bond yields are higher than long-dated yields, it is known as a yield-curve inversion. Many investors take this as an accurate recession predictor. It is important to note that an inversion doesn’t cause a recession. Rather, it reflects investor’s expectation that the central bank is hiking short-term rates too far and that they will be forced to backtrack, hence the lower long-term yields. Brazil’s yield curve is deeply inverted, for instance.

While US consumers, like their counterparts everywhere else in the world, face the squeeze from higher fuel and food prices as well as (slightly) higher interest rates, it is too soon to talk about a recession. The job market is still humming, as Powell noted – fewer Americans filed for unemployment benefits last week than at any time since 1969 when the population was considerably smaller – and households have a decent financial cushion. The same is true of companies.

Chart 1: US Treasury bond yields, %

Source: Refinitiv Datastream

It is not just US yields that have increased. European long-bond yields, long submerged below zero, are finally in positive territory. Indeed, the total global stock of bonds trading in negative territory has fallen from around $17trillion to low single digits according to Bloomberg estimates.

Chart 2: South African inflation, %