With the Fed expected to raise rates again next month after already raising them twice this year, Guggenheim Partners’ investment chief Scott Minerd has warned the central bank is at risk of pushing the US into recession.
Having slowly begun increasing rates in late 2015 after six years of historic lows, the Fed has increased the pace of its hikes in recent years, indicating two more rises before the end of the year and three more in 2019. With CPI rising to 2.9pc in July and unemployment at 3.9pc, chair Jerome Powell is now expected to give a hawkish outlook for the Fed’s September rate decision at his address to central bankers in Wyoming on Friday.
Fears that repeatedly increasing rates will lead economic growth to slow have already been expressed in the bond market. Indeed, the gap between 2-year Treasury yields and 10-year yields has narrowed to its smallest level since the lead-up to the financial crisis, creating fears of an inverted yield curve, a reliable precursor of recession.
Controversially, the Fed has also found a repeated opponent in President Trump, who recently told Reuters he was ‘not thrilled’ with the rates hikes. He added that he believes he ‘should be given some help’ from the central bank to boost the US economy.
In a recent Guggenheim investment update, Minerd points out that now nearly all Federal Open Market Committee (FOMC) members project that rates at end-2019 will be above their respective estimates of neutral. Despite policymakers expect rates to be 0.5pc above neutral by end-2020, Minerd argues that the market is sceptical that the Fed will get restrictive as it has priced in just three rises for the rest of the hiking cycle.
He expects six hikes, like the Fed, but he sees them all happening before the end of 2019, which he believes is enough to tip the US economy into recession. ‘With economic growth unsustainably high, the labour market tight, and Fed policy heading into restrictive territory, it is natural for the Treasury yield curve to flatten. We are positioned for further bear flattening toward out 3.25-3.5pc terminal fed funds rate projection over the next year, implying a roughly 50 basis point increase in 10-year yields from here. We maintain low credit exposure as we see an unfavourable risk/reward tradeoff given tight spreads, escalating trade tensions, and a recession approaching in 2020.’
For equities, the danger is clear- as many stocks are rooted firmly in the loose monetary policy of recent years if the Fed adopts a more hawkish stance then the rug could be pulled from underneath their valuations. With global indices already looking somewhat overcooked, despite the recent pullbacks, there remains a real risk of a significant global sell-off if rates rise too quickly.
Higher rates mean companies, like the US Government, will have to pay more when borrowing money and will have less room to increase returns shareholders – making stocks less attractive. Large stimulus programs like quantitative easing (QE) – which sees central banks create money by buying securities such as government bonds with cash that did not previously exist – have helped to prop up markets since the financial crisis.
QE has allowed the Fed to keep the cost of borrowing artificially low, allowing money to flow freely and thus providing firms with easy access to growth capital. But it has also led the amount of debt on the Fed’s balance sheet to reach its highest level in four years. It is only by returning to a standard policy stance that this can be corrected. Investors have been willing to accept higher valuations on US equities in part because interest rates have remained historically low.
But if interest rates rise too quickly, then a corresponding rise in bond yields could be devastating for equities, where an increasingly inverse correlation is being seen. In parallel with this, higher bond yields will generally make fixed income instruments more appealing to investors, potentially provoking a rotation out of equities into bonds.
Predicting the next bear market has confounded the vast majority of commentators for years. Until recently nothing seemed like it could get in the way of the market’s irrepressible move up. It is far from certain the party is over, but with the mood dampening over recent months we will keep a very cautious eye on the Fed’s activity going forward.
Author: Daniel Flynn