global perspectives

    When should the Fed pivot?

    When should the Fed pivot?
    Florian Ielpo - Head of Macro, Multi Asset

    Florian Ielpo

    Head of Macro, Multi Asset

    In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we discuss the potential timing of the Federal Reserve’s pivot away from its current hawkish stance and consider whether such a turn would actually be good news for markets.  

     

    Need to know:

    • Our nowcasting indicators expect the Fed to pivot from its current hawkish stance in Q1 2023
    • Markets agree with this timing, but see no reason for the Fed to then aggressively cut rates
    • In our view, the pivot will come as the economy collapses into a recession, meaning the Fed’s turn may not be good news for markets

     

    The Fed will turn – just not today

    Now that the big news is out – central banks are much more hawkish than expected – it is probably time to look through this news and consider the question of how long the Federal Reserve (Fed) will remain this hawkish and when will it pivot? In July-August, markets anticipated a pivot by year-end, as inflation numbers were coming down, but were proven wrong at the recent Jackson Hole summit. Investors now agree that the Fed and the European Central Bank (ECB) will hike more than expected, but how long can they manage to maintain this stance and what consequences will it have on markets?

    Tighter-than-expected monetary policy has been well signposted by our nowcasting indicators. Chart 1, showing the evolution of our monetary policy nowcaster, places both the Fed and the ECB in a situation with more hikes than expected. They have actually been in this elevated territory since Q1 2021 for the US, and Q4 2021 for the Eurozone. Prior to the war in Ukraine and the resulting commodity shock, the US indicator had started to come down only to quickly rise again when all lights turned green for central bankers to engage in a fight against inflation. Our US indicator peaked in June 2022 and the Eurozone in August; as long as the indicators do not fall back below their 45% threshold, these central banks should remain hawkish. Now, we can run simple calculations to estimate when the indicator will breach the 45% threshold, given its historical patterns. When our monetary policy nowcaster starts to decline it usually falls by 1-2% per month. Chart 1 shows the simulated trajectory of our indicators, taking that average decline into account. This places the Fed in a position to pivot around Q1 2023 and the ECB around Q2. From an investment perspective, this timeframe is essential as it is virtually the day after tomorrow.

     

    Chart 1: Simulated trajectory of our monetary policy nowcaster based on the hypothesis that the diffusion index remains below 50%

    Multi-Asset-simply-put-Simulated trajectories-01.svg

    Source: Bloomberg, LOIM

     

    What is priced in by markets?

    An important step is to consider what our models say compared with what the market consensus is saying. Chart 2 shows the evolution of the expected US monetary policy scenario between early August and early September (based on Fed fund futures). Prior to the Jackson Hole meeting, markets were expecting the Fed to hike until 3.5% and then hold its ground for a couple of months before slashing rates in anticipation of a recession during the second half of 2023. Since the meeting, that scenario has seen a triple revision:

    • The Fed’s pivot should happen by Q1 2023
    • The highest point of the tightening cycle should be 4%
    • Subsequent cuts should be limited as markets now expect the Fed to maintain higher rates for a longer period

    The latest scenario is quite close to the one coming from our indicators, especially in terms of when the Fed could stop being aggressive with inflation. Where we disagree with markets, and with the Fed, is that our indicator expects the Fed to cut rates more aggressively after Q1 because the US should be in a recession by then. The Fed seems to have convinced markets that rates can be higher over the medium term without the economy contracting.

     

    Chart 2: Recent evolution of the Fed fund market expectations

    Multi-Asset-simply-put-Market expectations-01.svg

    Source: Bloomberg, LOIM

     

    Will the pivot be good news for markets?

    In a scenario where the Fed ends its hiking cycle in Q1, what can we expect from markets? The answer to that question is complex and can be split into two different components:

    1. The rapid hikes we are seeing, and the rise in real yields that come with it, will weigh on equities and bonds together. A moderation of this situation should therefore be a relief for most markets and could lead to a normalisation of these correlations. For multi-asset portfolio managers, this normalisation will be a first step toward more positive performance overall: a time to breathe.
    2. Central banks could be derailed from their hiking cycle by something worse than inflation. The natural outcome of these hikes should be a recession, but that recession could trigger credit defaults and deteriorating earnings. The combination in the context of a diversified portfolio means that duration would probably become the only place to hide, leading to a classic “flight-to-quality” episode.

     

    Simply put, a central bank pivot could very well happen within the next six to nine months, as currently expected by markets. When it happens, it could be bad news, as a recession is likely to be unfolding by then.

     


    Macro/nowcasting corner

    The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

    Our nowcasting indicators currently point to:

    • Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating momentum while the most recent data shows that this deterioration has room to go
    • Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US
    • Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected

     

    World growth nowcaster: long-term (left) and recent evolution (right)

    Multi-Asset-simply-put-Growth nowcaster-05Sept-01.svg

     

    World inflation nowcaster: long-term (left) and recent evolution (right)

    Multi-Asset-simply-put-Inflation nowcaster-05Sept-01.svg

     

    World monetary policy nowcaster: long-term (left) and recent evolution (right)

    Multi-Asset-simply-put-Monetary Policy nowcaster-05Sept-01.svg

    Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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