Back in mid-January, all the talk was of when the US Federal Reserve would begin cutting interest rates – when would we see ‘the Fed pivot’? Judging by futures markets at the time, this was expected sometime in late summer or early autumn, with the fed funds rate forecast to reach 3.75% by the end of the year, down from an expected peak of 5%.
It’s back!
It was a view predicated on inflation slowing sharply. One-year inflation expectations had dropped by nearly 100bp from December 2022 levels to just 2% – far lower than the Fed’s forecast of 3% (or rather 3.5% if we adjust the Fed’s Personal Consumptions Expenditures forecast to equate with the market estimate for the consumer price index (CPI).
If inflation was going to be 150bp lower than initially thought, there would be no reason for the Fed to keep policy rates so high and policy could pivot from raising to cutting rates. This benign view on inflation was based on the data at the time, in particular, the CPI showing decelerating goods prices and low services inflation. If prices continued to fall at the same pace, 2% by the end of year seemed reasonable (2% also being the Fed’s target rate for core inflation).
Pivot hopes pummelled…
Such a scenario has largely disappeared. Firstly, the data has changed. Revisions to the US CPI showed much less goods disinflation than before, while services inflation was higher. Strong labour market and retail sales data has indicated that economic growth is still very strong. Inflation expectations have started moving up and are now back above 3% (see Exhibit 1).
Notably, this increase occurred despite broadly stable oil prices. This illustrates how inflation is being driven by core index components, not just typically volatile energy prices. Alongside the rise in inflation expectations, fed funds futures rates have reached a high of more than 5.25% and 10-year US Treasury yields have touched 4%.
During the ‘pivot period’, it was thought that inflation would fall to the Fed’s 2% target without the economy entering recession and that the price pressures would ultimately prove to be transitory. China re-opening its economy after the pandemic would lessen goods inflation, while wage growth was not all that far above the Fed’s preferred level.
Now it appears (again) that recession will likely be required to drive up the unemployment rate and bring wage growth down. Given the continuing strength of the economy, recession will likely start later in the year than initially believed, but, in our view, start it will.
But what about the markets?
Equity markets, however, continue to appear largely impervious to the developments in fixed income markets and this bleak-ish macroeconomic scenario. The S&P 500 index has risen by 4% from the point when inflation and policy rate expectations were at their lows. Last year, when policy rate forecasts rose, not only did equities fall, but growth style equities underperformed their value counterparts. This time, growth indices have clearly beaten value indices.
One possible explanation for this performance is that, thanks to the declines in markets last year, equities have already ‘priced in’ recession. Being forward-looking, equities are focusing on the recovery to come.
Earnings estimates, however, do not support this perception. There have been significant negative earnings revisions for US equities since last year. Earnings growth expectations for 2023 are now feeble, at just 0.3% compared with 2022, when 10% is historically the norm.
This low figure reflects the impact of rising input costs; that is, that companies will see margins squeezed rather than sales fall. Over the last year, sales expectations have been rising (partly reflecting inflation), while if analysts were expecting recession, sales forecasts would be falling (see Exhibit 2). If a US recession materialises, as we expect, earnings estimates will need to fall further.
It is the same – Eurozone inflation
The Fed is not the only central bank struggling with inflation. The ECB will likely have been dismayed by the latest inflation data for the eurozone. The figures showed core inflation rising to a high of 5.3%, nearly the same level as in the US at 5.6%, though at least US core inflation is declining.
As in the US, policy rate expectations have reached new highs and 50bp rate rises from the ECB appear assured in the months ahead. Ten-year German Bund yields are rising. High inflation partly reflects robust growth. The latest purchasing managers’ indices were generally higher than in the previous month and the services indices were above 50, indicating further expansion in activity.
In short, the ECB faces the same dilemma as the Fed: How far does it have to go to slow economic activity if it is to get a grip on inflation?
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