A rate hike on May 3 by the FED now seems a foregone conclusion

The past week was successful for the stock markets (S&P500 +0,79%, WIG20 +5,70%, sWIG80 +2,32%, DAX +1,34%), but less in the case of the treasury bond marketwhere 2-year yields US bonds increased by 11 basis points and 10-years by 10 basis points. On the other hand, the yield on Polish 10-year bonds increased by 13 basis points.

The past week also saw further increases in oil prices (the fourth week of increases in a row), as well as a strong increase Bitcoin (+7,1%), while the Nasdaq100 gained only 0,1% last week.

You might be tempted to say that stock markets have reached a certain level of "equilibrium" - and further significant upward or downward movement may be difficult in the short term. The hawks could be shaken out of such an equilibrium by the markets FED (rather unlikely before the May 3 meeting), or some other "break" in the financial markets or in the real economy (but it would rather have to be something new, because the "banking crisis" is slowly becoming history - at least in the short term).

Last week in the markets

Last week we got to know key macro data from the US, such as employment report in March, CPI and PPI inflation. While the employment report was published last week, due to the holiday break some markets may not have reacted to it until this week. The 2-year US bond yield change chart below shows the market's "interpretation" of whether the latest data was hawkish or dovish in terms of the upcoming Fed meeting on May 3. "Net net”, we can conclude that a rate hike by the Fed at the next meeting is much more certain after the latest data and hawkish statements by representatives FOMC (the current probability of a 25 basis point hike is 78%).

Change in the yield on the 2-year US treasury bond until April 14.04.2023, 6 - last XNUMX sessions. Source: own study, stooq.pl

While reports on CPI and PPI inflation were very well received by the market (at least in the comments), they did not have a major impact on 2Y US bonds (apart from short declines). In fact, in terms of interest rate hikes, the labor market (too strong) and what the FED intends to do about it are much more important (yesterday's hawkish message from C. Waller).

Rate hike on May 3 this year. now seems to be settled. The US economy remains relatively strong, the same can be said about the labor market, and falling inflation is still not enough for the Fed to start thinking about interest rate cuts (and the market certainly sees them ... and soon). In this context, let's look at how the market interprets the last and so far the only "crack" in the markets, i.e. the banking crisis. Since the economy is (still) too strong and inflation is (still) too high above the target, the "only" thing that could speed up rate cuts is a "rupture". The chart below shows various banking indices since the beginning of the US crisis.

Our short banking indices from March 08.03.2023, XNUMX. Source: own study, stooq.pl, ishares.com

Polish banks have already forgotten about the crisis, and large European and American banks are moving in a similar direction. Yesterday we got to know the sensational financial results of such banks as Well Fargo (EPS $1,23 - expected $1,12, revenue $20,73 billion - expected $20,12 billion) JPMorgan (EPS $4,10 - expected $3,41, revenue $38,3 billion - expected $36,16 billion), and Citigroup (EPS $2,19 - expected $1,70, revenue $21,4 billion - expected $20,05 billion). The good results were immediately reflected in the rising exchange rates of the banks, which cannot be said about US regional banks – at yesterday's session SPDR S&P Regional Banking ETF fell as much as 1,95%!

The next chart shows the "banking crisis" from the perspective of major equity indices.

S&P500, WIG20 and Nasdaq100 (from March 08.03.2023, XNUMX). Source: own study, stooq.pl

The chart below shows Polish indices since the beginning of the banking crisis.

Polish indices (from March 08.03.2023, XNUMX). Source: own study, stooq.pl

It can be said that today the banking crisis ceases to disturb the stock markets and is in practice limited to regional US banks. Therefore, at least in the short term, it is hard to expect that this "crack" could develop into a significant argument for rate cuts.

However, at least historically, something usually breaks at the end of the cycle of interest rate hikes, and if it is to be similar this time, it remains only to wait for it. Although it may be long months or even quarters - which does not exclude some earlier surprise - but the possible longer waiting period can be inferred from, for example, the average historical length of the pause after the last rate hike by the Fed - which is about 8 months. And a pause means… that nothing has broken then – because a “break” causes interest rates to go down.

What's next for the markets - some thoughts

The current cycle is completely different from the historical ones, although in my opinion it would be hard to say that the traditional "boom-bust" order will not work anymore (that would mean a soft landing, or just a mild recession - which subjectively gives only a 20% probability). Here are some brief considerations:

1. Currently, markets are not pricing in a classic recession scenario and continue to focus on central banks' "fight" against inflation. This can be seen from the generally "together" movements of bonds and equities. Stocks rise as government bond yields fall, whereas in a recession stocks should fall as bond yields fall and the Fed cuts rates. This stage is not yet, because the Fed does not even have to think about rate cuts yet.
2. In the "soft landing" scenario, an increase in inflation in the US to 9% and the FED rate to 5,25%, and then a decrease in inflation to 2% of the target, and finally also interest rate cuts by the FED to much lower levels, does not cause a recession or a strong slowdown in economic growth . Possible? Yes, but unlikely.
3. The lack of valuation of the recession scenario is also visible in the current consensus of expected operating profits for the S&P500, according to which profits in the current cycle will fall by only 4% (decrease in EPS from high to low). For comparison, during the brief recession in 2020, corporate profits fell by 15%, during the 2008 recession by 34%, and during the 2001 recession by 28%.
4. Is the debt market right in pricing in quick rate cuts by the Fed? Not necessarily in the short term. The historical "relevance" of the market is very weak. For example, I can give you the period from 2009, when the market started to price in rapid rate hikes by the Fed (at that time the Fed rate was at zero) and priced them in practically continuously until the first hike in December 2015. In other words, the market has been "wrong" continuously for 6 years. Currently, it may be similar that the shape of the curve pricing the future path of interest rates will not change (all the time down), but will only move forward in time ... until the FED actually starts cutting. Of course, we will rather calculate it in quarters, not years, because for obvious reasons, it can be expected that the maximum level of FED rates is much shorter than the minimum level (it does not apply to the scenario of inflation returning to higher levels, but such a scenario, if it happens, is already not in this year).
5. However, the key to “finishing” the cycle remains the FED, which currently raises rates, not lowers them. Will the Fed have to cut rates this year? Yes, but only if "something forces him to do it". Currently, falling inflation can be "ignored" by the FED (after all, it is still above the target). The labor market does not help in interest rate cuts (the unemployment rate is at the bottom of the cycle). Good moods in the financial markets (e.g. rising share prices) also do not help in interest rate cuts, because financial conditions are easing (equivalent of rate cuts). A relatively strong economy also does not help with interest rate cuts (the current forecast of GDP growth in Q1 according to the Atlanta FED model is 2,5% - which is certainly above the economy's potential).
6. So what can help the Fed cut rates? Various leading indicators that point to an imminent recession. Even in the final minutes of the Fed, there is a record of a mild recession coming. But the Fed's mandate is not for leading indicators, but rather for series that are well lagging in the cycle - like employment or inflation rate!
7. But it may even be in favor of the Fed, because historical experience in fighting inflation rather indicates the need to leave rates at a high level for a longer period.     

Summation

The past week turned out to be slightly positive for the stock markets and slightly negative for the bond markets. Equity markets seem to have reached a point of “suspension/suspension” – from where further significant upward or downward movement may be difficult in the short term. The strongly hawkish FED, the return of inflation, or some other "crack" of something in the financial markets or in the real economy could throw the markets out of such balance (but it is unlikely that this will be the last "banking crisis" that is slowly passing into history).

Even though the markets see/price in imminent interest rate cuts (which de facto may be the "basic fuel" for stocks to rise), but the FED currently has "great comfort" in opposing the market. In other words, it is difficult to indicate, at least in the short term, what would "force" the FED to cut rates quickly.

But the current cycle will end anyway with the FED's rate cuts. Either they will be cuts due to the lack of recession and overcoming inflation (then we could start a new boom in stocks more or less from the current relatively high levels), or we will face a recession/possibly a "crack" of something in the economy/markets - then the rate cuts will mark the beginning a new bull market, but probably from lower levels than the current ones.

About the Author

Jaroslaw Jamka - Experienced fund management expert, professionally associated with the capital market for over 25 years. He holds a PhD in economics, a license of an investment advisor and a securities broker. He personally managed equity, bond, mutli-asset and global macro cross-asset funds. For many years, he managed the largest Polish pension fund with assets over PLN 30 billion. As an investment director, he managed the work of many management teams. He gained experience as: Member of the Management Board of ING PTE, Vice-President and President of the Management Board of ING TUnŻ, Vice-President of the Management Board of Money Makers SA, Vice-President of the Management Board of Ipopema TFI, Vice-President of the Management Board of Quercus TFI, Member of the Management Board of Skarbiec TFI, as well as Member of Supervisory Boards of ING PTE and AXA PTE. For 12 years he has specialized in managing global macro cross-asset classes.

Disclaimer

This document is only informative material for use by the recipient. It should not be understood as an advisory material or as a basis for making investment decisions. Nor should it be understood as an investment recommendation. All opinions and forecasts presented in this study are only the expression of the author's opinion on the date of publication and are subject to change without notice. The author is not responsible for any investment decisions made on the basis of this study. Historical investment results do not guarantee that similar results will be achieved in the future.