Why market fears of an abrupt end to the growth cycle are premature

In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we assess whether markets are right to price in a premature end to the current growth cycle.

 

Need to know The Fed and other central banks are beginning to phase out monetary stimulus policies. A sharp decline in long rates suggests markets anticipate this tightening could bring the current growth cycle to a premature end. But it would not be the first time that markets have made a forecasting error in relation to monetary policy. We believe it is too early to fear a recession yet.

 

The Federal Reserve's (Fed) latest statement had a rather surprising effect on markets. The tone of the speech was more openly hawkish, with the Fed acknowledging that its temporary inflation scenario may recede. This is not a total revision of its core scenario, durable inflation continues to be a risk and the probability of this scenario happening has increased recently.

To illustrate this, figure 1 shows the evolution of monetary policy expectations in the United States. In June 2021, the market was expecting the Fed to hikes rates twice over the next four years: a scenario that now seems highly unlikely as seven rate hikes are now forecast over that same time frame. Fed chairman, Jerome Powell, has apparently been successful in distilling the idea, across markets, that the first hike could occur sooner than had been expected; the market now expects a 25bps increase will take place in August 2022, followed by another hike in December 2022. This game of expectation must be fully understood in order to grasp the difficulty of how the Fed, the European Central Bank and the Bank of England will steer their respective cargo ships (their balance sheets) going forwards. 

If the tone of the Fed’s speech did indeed convince markets of an imminent rate hike, it had a secondary, even more surprising effect: long-term rates plunged by nearly 20 basis points (for the 10-year tenor), a drop that was further amplified by the encouraging employment report published shortly after. More growth = lower rates? To us, that's the really surprising scenario.

 

Figure 1. Evolving expectations of US short rates implied by Fed fund futures

 

 

Source : Bloomberg, LOIM

 

Underestimating the scale of rate hikes

To understand the origin of this unexpected move, it is essential to consider the mechanics of the yield curve. Every student of finance is taught that spot rates are an average of forward rates – i.e. the 2-year spot rate is an average of 24 month-to-month forward rates. These forward rates are anchored around the future decisions of central banks and a spread is then added (depending on the type of rate being considered). The yield curve (spot and forward) is therefore a fantastic tool for anticipating the future, especially central bank policy action. Yet, it’s also important to consider the quality of this forecasting tool.

A paper by Piazzesi and Swanson, published in the Journal of Monetary Economics, indicated that markets forecast monetary policy well over a full economic cycle; however, forecast errors occur cyclically and exhibit oscillations that visually form a continuous wave (or sinusoid shape). This analysis concludes by suggesting these waves coincide particularly well with the classic indicators of the business cycle, such as the ISM manufacturing index or the US employment report. Figure 2 presents an updated version of these results.

Even though the period of zero interest rates has eroded the strength of these conclusions, the spirit of Piazzesi and Swanson’s original findings remains intact for both the US and the Eurozone. Market forecasting errors relate to the economic cycle; when growth is strong, markets tend to underestimate the magnitude of rate hikes. With this in mind, a simple regression analysis suggests, to us, that markets could be underestimating the scale of rate hikes over the next six months. This may seem extreme, but we believe the tone has been set: what lies ahead will be increasingly less accommodative monetary policy, which risks potentially surprising the market.

 

Figure 2. Market forecast errors versus cycle indicators in the US (left) and Europe (right)

 

Source : Bloomberg, LOIM

 

Are markets being too pessimistic?

If we assume this anticipation mechanism characterising the yield curve is correct, it helps us understand the fall in long-term interest rates. Most of the recessions during the last 100 years did not reflect an exogenous phenomenon (aside from the Covid-19 pandemic). In other words, economies do not fall into a recession without being pushed first. And it is usually central banks providing this impetus.

Market are beginning to anticipate that the Fed, and other central banks, are aiming to slow growth gradually as short rates rise. Yet, markets lack faith in a controlled slowdown of the recent expansionary phase and fear that rate hikes (which may be more intense than expected, according our Piazzesi and Swanson analysis) could bring it to a premature end. However, we so not believe we are at this point yet as such scenarios don’t tend to occur at the beginning of an expansionary phase, but during the slowdown.

In our view, monetary conditions should remain favourable, given the current levels of nominal growth, and global growth should remain strong. Long rates may be declining once again but this situation is not sustainable: with 8% nominal world growth forecast for 2022, and wage increases closer to 2003-2007 than to 2009-2019, we believe that long rates will return to higher levels in the weeks to come and that markets are probably being too pessimistic right now.

Simply put, rates seem to be reflecting the start of a monetary cycle that will bring us to the brink of a recession. We believe this is premature given strong global growth and rising wages – forces that should arrest the decline of long rates and drive them higher.

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