US rate outlook and impact on stocks

There was a big reaction to the Federal Reserve’s Jerome Powell’s bi-annual testimony to Congress about monetary policy on Tuesday. These testimonies are usually dull, but yesterdays changed the dial for US monetary policy and the outlook for stocks and risk assets globally. Here’s why:

·      Powell said that the Fed is prepared to speed up the pace of rate hikes on the back of hotter than expected US economic data, for example, jobs, spending and inflation.

·      This opens the door to a 50-basis point rate increase at this month’s meeting, last month the Fed slowed down their pace of rate hikes to 25 basis points.

·      The market rapidly repriced its expectations for the Fed rate meeting on 22/3, there is now a 73.5% chance of a 50bp rate hike, up from a 29% chance last week.

·      US stocks tanked; the Dow was down more than 500 points.

·      US 2-year yields jumped 22 basis points at one point on Tuesday and rose above 5% for the first time since July 2007.

·      The US yield curve (the spread between 10-year yields and 2-year yields) fell further into inverted territory, and is now -103 basis points, its most inverted level since September 1981, when Paul Volcker was in charge at the Fed and imposed double digit interest rates to bring down inflation.

·      Powell’s testimony has flashed a red warning sign about the US economy that it is heading for recession.

·      The market is now pricing in expectations for rates in the US to peak at 5.6 and to stay at this level until early 2024.

The implications:

·      In the short term, Powell made it very clear that the Fed will react to the incoming data. If it continues to come in hot, then the Fed may have to raise rates at a faster pace, and the terminal rate may have to be higher than currently expected.

·      But, has the market over-reacted? If we see a weaker jobs report on Friday, could Tuesday’s price action be reversed?

·      We think yes, if jobs growth is less than 200k, and if there are downward revisions to January’s mega 517k, then expect stocks to rise and bond yields and interest rate expectations to fall.

·      But, if we do get strong jobs report this Friday, the risk of the market pricing in a 6% or above terminal rate is high, this is bad news for US stocks as it increases the chance of a recession, and a longer earnings recession in the future.

·      It also highlights the risk of forward guidance - the market can get confused.

·      Did Powell tell us anything we didn’t know already? No. However, the market likes certainty, and the Fed can’t be certain about interest rate strategy bringing down inflation. This is hard for the market to price in.

·      The impact for markets: stocks that are perceived as overvalued could struggle along with the tech sector. It could cause some managers to prefer European stocks over US stocks due to the cheaper valuations this side of the Atlantic, for the coming quarters.

Powell will speak again to Congress later today, but he should stick to the same script as Tuesday, and we don’t expect any more surprises.