Although Wall Street and European markets had dipped slightly by Wednesday (5 October), Tuesday’s moves took the S&P’s advance over two days to 5.7% – its strongest rally since the start of the Covid-19 pandemic in early 2020.
The rally followed the release of cooler US labour market data, which helped ease some concerns about the pace of the Federal Reserve’s interest rate rises. Talk of a possible pivot from the Fed also intensified after Australia’s central bank delivered a smaller-than-expected 25bp interest rate hike.
On Monday (3 October), Morgan Stanley’s CIO Mike Wilson said that just like the Bank of England was forced to intervene last week by purchasing long-dated bonds, the Fed will also likely have to intervene in a similar fashion, whether that means pausing rate hikes or full-out quantitative easing.
However, several economists and investment strategists told Investment Week that financial markets seemed too optimistic about the prospect of a Fed pivot.
Keith Wade, chief economist at Schroders, said that the firm’s view is markets will get a Fed pivot, but not until next September, when the central bank will have seen “sufficient progress” on inflation and weakness in growth to be confident of signalling a rate cut.
Silvia Dall’Angelo, senior economist at Federated Hermes, said that while expectations of a central bank shift had increased within in financial markets, the central bank had made clear it was determined to hike rates into restrictive territory until it saw inflation come back down towards target.
However, she noted that although volatility in financial markets is accepted from a Fed perspective, “the risk of severe market dislocations potentially leading to a systemic event has increased substantially”.
“Central banks will have to take note, given financial markets are one of the main transmission channels of monetary policy to the real economy,” she said.
Anna Stupnytska, global macro economist at Fidelity International, said that the chances of the Fed changing course this year were low, and that one, or even several, soft jobs reports are unlikely to be enough to sway the Fed.
“Despite some signs of weakening, the US economy is still strong and we believe inflation will be sticky at higher levels throughout 2023. The pivot will not come until there is a consistent deterioration in US macro data,” she said.
Guillermo Felices, global investment strategist at PGIM Fixed Income, said that the market participants’ hopes for a quick pivot in the face of market stress are “misplaced”, noting that the Fed’s reaction function during periods of high inflation is “a lot less sensitive to financial conditions than what we have been used to post-2008 financial crisis”.
“The bar for such pivots is a lot higher now that inflation is high and persistent. We cannot rule one out soon, but if we see one it will likely mean that the economy and financial markets are in real trouble,” he said.
Melanie Baker, senior economist at Royal London Asset Management, echoed this sentiment, agreeing that talk of a Fed pivot appeared premature.
David Riley, chief investment strategist at BlueBay Asset Management, noted there was a danger that markets get ahead of themselves in hoping for a Fed pivot, as they did in July when risk assets and bonds rallied strongly.
“The Fed will lean against any sustained market rally that prematurely eases financial conditions until it sees ‘clear and compelling evidence’ that inflation is converging to its 2% target and its job is done,” he said.
Recalibration of expectations?
Although a change in Fed policy may be too early to call, some experts said there was some value in the idea that central banks might not need to choke off economic growth as aggressively as previously thought.
Eric Lascelles, chief economist at RBC GAM, noted that many of the original drivers of high inflation have turned, and as central banks scramble to regain their credibility, “they are heavily incentivised to promise more tightening than should strictly be necessary”.
Markets are recognising that not all of this tightening may prove necessary and are recalibrating expectations, he added. However, Lascelles noted that while inflation remains high, central banks still have a fair distance to travel and economies are likely to tumble into recession.
“As such, it is probably premature to imagine that risk assets can continue to soar from here, even if the recent adjustment has arguably been a rational one,” he added.
Haig Bathgate, head of investments at atomos, formerly Sanlam Wealth UK, said that the chance of a pivot from the Federal Reserve’s current bearish stance is much higher than is currently priced in by the markets, given the similarity between US and UK housing market dynamics at present.
“A big factor in the US Federal Reserve’s thinking will be in relation to what happens in the housing market,” he said, adding that over the past seven weeks alone, the US 30-year mortgage has increased by 1.3% to 6.75%, more than doubling from 3% just one year ago.
“Property is driven by marginal demand/supply and as we start to see more and more consumers struggle under the burden of both higher living costs and increased mortgage costs at the refinancing stage, this can have a disproportionate impact on the property market,” he added.
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