Weekly market update – Why the rate debate is a moot point

One: Markets don’t 'predict' interest rates.

A pitfall I myself admit I’m sometimes guilty of. The 'market implied expectations' tool simply looks at the futures curve and 'implies' that if market participants are completely rational actors then, based on their present positioning, six rate cuts are implied. However, anyone who’s actually traded anything knows that financial markets are the summation of rational expectations, Fear of Missing Out (FOMO), arrogance, herd behaviour, algorithmic trading and some pretty big egos pitted against immense insecurities. It’s not too different to poker really, and like poker, those who master their psychology and use other people’s psychology to their advantage, tend to win out. Bonds especially, which feature a lot of institutional investors, such as pension funds and central banks, also have an element of significant mandated institutional buying and selling.

So instead of saying 'markets predict', a much more accurate way to put it is that ‘for the bonds to be fairly valued in the futures market, the Fed would have to cut rates six times’, or simply ‘futures bond markets are positioned for six rate cuts’. It’s longer and less SEO-attractive than ‘markets predict’, but it’s certainly more accurate.

So, at their current positioning, futures bond markets are pricing in double the Fed’s predicted rate hikes.

Two: The Fed can be either data-dependent or forward guiding, but not both.

The Dot Plot tool was created at a time of so-called ‘forward guidance’. It is an internal anonymous survey of FOMC members about where they see rates in the next two years and over the longer term. At a time of Quantitative Easing and forward guidance, it was an informal commitment of forewarning markets six months ahead of major moves, in a bid to further repress volatility after the GFC. After inflation became volatile, central banks moved towards ‘data-dependency’ i.e., they would act according to the incoming data. As models and data about inflation date back to the 1970s-1980s, a time of Cold War, oil addiction and very different demographics, their dependency can be fairly questioned. And even with that data and hindsight, we can only see averages, and have to ignore volatility. But a data-dependent Fed doesn’t have the benefit of hindsight and no matter how much it smooths the data out, it can’t ignore inflation volatility altogether. Thus, the approach was more simplistic. If certain indicators point to higher headline inflation, the Fed would be aggressive. Inflation picking up for a second consecutive month could invite a more hawkish stance.

Data-dependency and forward guidance can’t co-exist peacefully. So while the Dot Plot surprised markets positively it oughtn’t be taken as a commitment going forward. The Fed is simply over the forward guidance phase.

Three: The real issue is Quantitative Tightening.

The problem right now is that investors are focusing on the wrong thing. Bond and equity markets have already moved. Bond markets are positioned for six rate cuts this year and equity markets are at all-time highs.

So the move predicting rate cuts has already happened. Whether those actually occur in the summer (less likely because the economy is on a positive path), autumn or winter (more likely) is beside the point for longer-term asset allocators.

Whatever the case we are at the point in the cycle where growth begins to matter at least as much as inflation.

It’s only a question of how much volatility investors can take until valuations catch up to expectations, an all-too-familiar trope of financial markets. In other words, we spend too much time wondering about an issue that will, even if they get it wrong, simply put investors through what will at worst be an extra six-month period of higher volatility. 

But whereas we know that interest rates will probably come down at some point this year, what we don’t know is when Quantitative Tightening (QT) will stop. Why is that more important? Because QT can hamstring the sustainability of the equity recovery.

The Federal Reserve is currently draining c. $80-$100 billion per month from financial markets. For fourteen years, investors knew that Quantitative Easing drove returns for risk assets. Its counterpart should have the opposite effect, or at least hinder a sustainable bull market.

Except for the obvious effect on risk assets, especially for bond yields in an era of significant fiscal expansion, it also sends a signal to market participants to be careful when they buy an asset, since there’s a very powerful seller where there was previously a very powerful buyer (powerful enough to thin out the market for many a bond trader). And we need to remember that the ECB is contracting its balance sheet at double the pace.

Currently, there’s no word from either as to what the roadmap looks like for ending QT. It could be at the time of the first cuts. After all, it makes little sense to cut rates for the economy but keep squeezing the markets. It could be earlier, as central banks see commercial bank reserves dwindling close to the edge of what is their level of comfort. Or it could be later. We simply don’t know yet. And until we do, that’s what we, as investors, need to focus on learning.

Interest rates are the trees. The forest is Quantitative Tightening.

George Lagarias, Chief Economist

This article was featured on Wealth DFM.

Market update

Last week, global equities saw a return of +1.1% in GBP terms. With the Q4 earnings season in the US beginning last week, US stocks outperformed, returning +1.7%, while European equities saw more modest returns of +0.2%. UK equities were the outlier in developed markets last week, experiencing a slight downturn of -0.8%.

Despite continued Yen weakness, Japanese equities delivered excellent returns of +3.7% in GBP terms, as investors reconsider the Bank of Japan’s timescales for monetary policy normalisation. Meanwhile, emerging market equities saw marginal declines, falling -0.6%.

Within fixed income, the US 10-year Treasury yield decreased from 4.05% to 3.96%, a change of 9 basis points, while the UK 10-year Gilt and German 10-year Bund yield increased slightly to 3.87% and 2.15%, a change of 4 basis points and 2 basis points respectively.

In the commodities market, gold prices fell slightly in GBP terms, to $2055.65/oz, while volatility in oil prices continued, as tensions across the Middle East escalated.

Finally, the recent trend of US Dollar weakness against the British pound continued, with Sterling appreciating by +0.2%.

Macro news

Consumer prices in the US increased by 3.4% in the year through December, beating expectations of a 3.2% rise. The rate was the highest seen in three months as services inflation remained stubborn at 0.4% over the month of December, while a flat reading in commodities less food and energy over the month bucked a recent trend of disinflation within goods. Services inflation was mostly driven by car and housing costs in December. Core inflation was in line with expectations, with a monthly rise of 0.3% and a year-on-year rise of 3.9% (versus 3.8% expected). A slowing of goods disinflation is unwelcome news to the Fed, as it had been a key driver of easing inflation over the last few months.

An index measuring the business optimism of small companies in the US increased by more than expected in December. The index, published by the NFIB, rose to 91.9, beating forecasts of 90.7 and hitting the highest value since July. While the figure shows that business owners are more positive about the economic prospects for the coming year, the index remains below its long-term average of 98. Small business owners found inflation and replacing labour quality to be their biggest areas of concern.

UK GDP expanded by 0.3% in November, rebounding from a 0.3% decrease in October. The services sector was the main contributor to the growth in GDP, owing to growth in information and communication, repair of motor vehicles, professional scientific and technical activities, and health and social work activities.

The week ahead

In the UK, investors will be watching out for the ONS’s labour market report as well as figures for inflation and retail sales for December. In the US, retail sales figures will also be released, as well as the results of the University of Michigan’s consumer sentiment survey.