And then there were none: What’s the impact of the Fed’s 'Higher for Longer'?

Forecast the future too accurately, people might get angry, or they might pressure you to do it again until you eventually fail. In both cases, they end up hating you. Forecast the future too loosely, and they don’t trust you from the start. Forecast good news that doesn’t play out or misses expectations or just forecast bad news, independent of whether they play out or not, people still hate you. Only forecasting good news early and always right will make anyone like you. All other outcomes are bad. The problem was that so many bad outcomes don’t make for a good business model. And Apollo’s priests needed money.

Thus did Pythia chew psychotropic leaves and give very wide predictions, for people to read into them their own desires. The late Daniel Kahneman would call this 'confirmation bias'.

Rich merchants were the best clients. A lot of money, no complaints, lest one risk upsetting the vengeful and prickly God. But once in a blue moon, there came a real crisis, and Pythia needed to be extra careful. In 480 BCE, a few weeks after Xerxes defeated Leonidas and his 300 (more like 1500 but why mess with a good movie) in Thermopylae, he marched on Athens. The city was doomed. So officials run to Pythia and asked her what to do:

“Wooden walls will save the city”, she exclaimed.

Half of them understood 'Wooden walls' to mean Athens’ powerful navy. The other half took it literally, barricaded themselves on the Acropolis and build wooden walls around it. The first cohort emerged victorious in the famous battle of Salamis, which turned the tide of the Persian Wars and preserved Western civilisation. The other ended up ridiculed by Herodotus, not to mention unceremoniously barbecued. Old Pythia smiled. She was right either way.

The point is that forecasting is, for the most part, little more than a brain exercise of little consequence. Wide predictions serve marketing purposes. Accurate predictions, done properly, must always update the forecast with new information. “When the data changes, I change my mind. What do you do?”, John Maynard Keynes famously said. But once in a while, a forecast is so important that it needs to be right from the start, exposing the limits of this brain exercise.

What is the forecast the world has been waiting for? When will American rates come down? Little is more important, or more difficult than trying to predict interest rates in an age of unstable inflation.

In the past decade and a half, after the 2008 Global Financial Crisis, the investment world turned to ‘Fedwatching’. The Federal Open Markets Committee is comprised of roughly 18 individuals, 12 of whom are voting at any given time. We dissected every word, every preposition, compared these against previous statements, and reached our conclusion. The Fed called it 'Forward Guidance'. Scarred after the GFC, they wanted to make sure that investors had ample warning before any rate moves.

Forward guidance worked well in an environment of low economic volatility we called 'The Great Moderation'. Chinese exported deflation created a stable inflation, and thus growth and rate environment for a long time.

But, as we know, inflation can throw a major spanner in the works, upsetting growth and rate forecasts. One of our key calls a year ago was that the ‘Great Moderation’ is dead, and with it, the ability to forecast rates. Thus, before last October, the Fed maintained a hawkish stance, leading the markets to believe that 2024 would see no more than one or two rate cuts, if any. Lower inflation data in October, and a very dovish Dot Plot in December, led markets to price in seven cuts. Persistent inflation data thereafter shifted the Fed’s rhetoric once again, to the point where now markets are wondering if there will be any rate cuts at all.

As we said, a good forecast is the one that adjusts to the new data. And in an era of high macroeconomic volatility, that means it will likely change often. If the Fed, who is the primary stakeholder and ultimate decider of the interest rate in the world’s reserve currency, can’t get it right from the start, what’s the point of anyone else trying?

The problem is that it’s one of those situations where people have to try anyway.

Who cares about the Fed?

Often, we will hear: who cares what the Fed does? It makes sense for people to think in local terms. But money and markets are global concepts and interlinked.

A $114tn equity and a larger bond market, as well as millions of listed and non-listed businesses around the world, depend on getting this call right. So do other central banks. The US Dollar is the world’s reserve currency, and the American market the deepest and most efficient. Its borrowing rates affect all businesses. 

Two weeks ago, at the IMF meeting in Washington, the BoE’s Andrew Bailey and ECB’s Chritine Lagarde both suggested that the UK and the EU are well on their way to cutting rates this year, despite the Fed’s qualms.

This makes sense. The European economies are projected to have less than a third of US growth, mostly fuelled by debt and private credit, and less inflation by the end of the year.

But neither the BoE nor the ECB can lower rates too much, even if they have room to, as long as the Fed holds its rates 'higher for longer' for fear of significant capital outflows. Just look at what happened to Chinese FDI when the rate differential between the Fed and the PBoC grew too big.

When you own the world’s reserve currency, a high rate is an easy way to attract foreign money. While a more expensive currency could have an effect on US exports, it’s good to remember that America is not an export-led economy. At 11% of GDP, the US ranks 140 out of 149 countries measured by the World Bank in terms of export reliance, and dead last versus its major economic partners. With exports not a major concern, American policymakers might welcome a lower cost of imports.

Since 2016, throughout two different administrations and thus quite possibly a third, the US has been prioritising domestic growth at all costs. Higher growth, at a time of higher and unpredictable inflation, brings with it higher interest rates. And this compels America’s trade partners to maintain higher rates, even if they don’t necessarily want to.

What does this all mean for investors?

Uncertainty over when rates will come down seems to affect equities less and bonds more. By and large, the equity market has decoupled with either the Fed’s balance sheet or rate announcements and focuses more on earnings and technology’s potential in the era of Artificial Intelligence. But equities can’t ignore rates forever. Over the longer term, persistently higher borrowing costs are going to erode the quality of leveraged balance sheets, first for smaller and gradually for higher capitalisation firms.

Meanwhile, the bond market necessarily focuses on the duration trade, which now is a higher risk one. Conservative investors might shy away from higher duration, whereas aggressive investors, and those with the patience and liquidity to wait, could be willing to take on more risk.

While our cardinal rule has been and shall remain, that we 'don’t fight the Fed', we now know that 'forward guidance', be it through the Dot Plot or statements, is less potent than before. In other words, the Fed’s prediction on rates and inflation is possibly as good as anyone else’s in the market. This creates a world of opportunity but also necessitates money managers to focus on risk.

George Lagarias – Chief Economist

Market update

Equity markets finished strongly last week after a series of data surprises, both in earnings announcements and economic indicators. US stocks rose early in the week, as PMI data was weaker than expected, suggesting a higher probability of earlier rate cuts. Much of the gains were given up midweek, after Facebook’s parent company Meta Platforms issued weak revenue guidance, causing its shares, as well as the shares of other mega-cap technology companies, to sell off. Thursday and Friday saw a strong rally however, as robust earnings from Google and Microsoft won over a mixed first-quarter GDP report from the US, in which PCE inflation surprised to the upside, but growth was significantly weaker than expected. In all, US stocks rose by +2.4% over the week.

Other equity markets followed suit. UK stocks rallied to a new record on Friday, rising by +3.1% over the week, outperforming the US. EU also stocks rose by +2.3%, while emerging markets stocks rose by +3.5%. Japanese stocks were an outlier in GBP terms, falling by -0.8%, mainly due to a sharp fall in the Japanese Yen.

US Treasuries responded strongly to US PMI and GDP data, ending the week at 4.62%, an increase of 5 basis points over the previous week. UK 10-year Gilt and German 10-year Bund yields both increased by 7 basis points over the week to 4.31% and 2.57% respectively.

Oil was up by +0.6% while gold fell by -1.8% over the course of the week.

Macro news

On Tuesday last week, news of weak US economic activity permeated markets as flash US Composite PMI data for April dropped to 50.9, indicating that business activity is still increasing across the US, but at the slowest rate since last year. Concerns over new business activity were echoed across both the manufacturing and services sectors. Meanwhile, both input and output cost inflation decelerated and tentative signs of an unravelling of the tight US jobs market were observed, as respondents expressed a mild reluctance to backfill positions following staff departures.

Markets also reacted strongly to the simultaneous release of slowing US GDP growth and accelerating Personal Consumption Expenditures (PCE) inflation, often touted as the Fed’s preferred inflation gauge. US economic growth came in sharply lower than anticipated, increasing just 1.6%, versus economists’ expectations of 2.4% growth, while PCE inflation rose to 2.7% in March. The fear of a stagflationary scenario (low growth accompanied by inflationary pressures) weighed on asset prices last Thursday.

Meanwhile the European Central Bank (ECB) remains firmly constructive on the likelihood of a June rate cut, thanks primarily to less resilient economic growth on the European continent. However, further rate cuts are far from assured, as there are challenges associated with cutting rates while the Federal Reserve remains tentative. Aggressively cutting rates before the Fed could stoke a resurgence in inflationary pressures in Europe, going against the ECB’s primary monetary policy objective of price stability.

The week ahead

While market participants anticipate there will be no change to the Federal Funds Rate this week, investors will be primarily focused on the rhetoric adopted by Federal Reserve Chair Jerome Powell following the Fed’s interest rate decision on Wednesday. Investors will be also be able to carefully assess European growth prospects this week, with GDP data being released on Tuesday for a number of important economies, including France and Germany.