Welcome back guys, I know you missed me on Tuesday with the article; I was working away on a project which I’ll soon share with you guys…
As for now, we will depict:
The Federal Reserve meeting, the hike, tonality & message received by asset markets
The bond market’s reaction to the Fed minutes
How interest rate sensitivity affects central bank policy
As always lend me your attention from here on out
Are We About To See A Fed Pivot?
That’s the question most were trying to figure out from Jay Powell’s speech after raising rates to 4.00% from 3.25%, a raise of 75bps, the fourth consecutive rate increase of that size, as priced in by the market.
To be direct, the answer is no. We are far from seeing a pivot, let me explain why.
“The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done.”
— Chair Powell, Nov 2nd, Fed Meeting
That sounds pretty hawkish to me if you’re going to ask. In the current situation we’re in, that being; rising interest rates globally, elevated inflationary pressures, risk of fragmentation within economies particularly with the Euro Area and rising debt vulnerabilities amongst emerging/frontier markets, the Fed avoiding the widely anticipated pivot in policy has both positive affects for the U.S but rather negative affects for other major developed economies such as the Uk, Euro Area, Canada & Australia. I’ll quickly dive into this now.
Sensitivity to interest rates plays a monumental role within the decision making of central banks to either continue the fight against inflation or to pivot monetary policy to avoid financial conditions blowing up. Here’s why. Take the housing market, one of, if not the most interest rate sensitive sectors; in the U.S, although mortgage rates are pushing 6%, the average existing home owner doesn’t have to worry about rising interest due to their fixed rate being 10 - 30 years. Meaning there’s no immediate effect as homeowners would have to wait until maturity until they are at risk from interest rate volatility. Now, the dynamic in the Uk, Australia and Canada are completely different to that of the U.S.
The average rate of a fixed term mortgage in the Uk is typically a 2-3 year fixed rate mortgage as supposed to a 30 year mortgage in the U.S; meaning, there’s more exposure to interest rates volatility due to the shorter fixed rate period. In Australia the average fixed term is also 3 years and in Canada the average term is 5 years. So you can see, the interest rate sensitivity of the British, Canadian and Australian economies prevents their respective central banks from following the Fed on the path of aggressive tightening due to the overgrowing risk in their housing market imploding.
From figure 1, I hope the picture becomes more vivid what the housing market will experience over the next 2 years as over 1.8million home owners in the Uk will be forced to refinance in 2023 at elevated rates north of 4-5%!
So what effect does this have on the Pound, Australian Dollar and Canadian Dollar?
Very simple answer, further weakening on the respective currencies. It’s a lose lose; you tighten monetary policy in line with the Fed your economy, particularly housing as outlaid, is the first to crumble, leading to a weaker FX exchange rate. You pivot to a dovish standpoint, you now stand to lose foot against the dollar due to the interest rate differential between the central bank and Federal Reserve as the Fed continue ahead with hikes.
Back to the Fed meeting now. Here’s two more statements made by Jay Powell further reinforcing his hawkish stance on monetary policy:
“t's very premature in my view to think about or be talking about pausing our rate hike”
— Chair Jay Powell
“we'll want to get the policy rate to a level where it is, where the real interest rate is positive”
— Chair Jay Powell
If I’m being honest, I was expecting a Fed pivot, I priced in the Fed moving in sync and unity with the smaller central banks that have begun to show signs of slowing down i.e the ECB, BoC, RBA. As always, you can never predict the actions of the Fed, now knowing how interest rate sensitivity influences central bank decision explains why we may have not seen an expected pivot; their most interest rate sensitive market can handle the increase in rates. However, I’d expect to see a sharp cut back in jobs across the real estate industry in the U.S but also globally as demand completely evaporates due to unsustainably high mortgage rates for those shopping for homes in the U.S and existing/new home searchers elsewhere across Europe & North America.
Yields in the U.S fixed markets are soaring as investors are repricing the hawkish message and intent from the Fed moving forward causing the inversion across the 2s10s to widens even more. (Shown in figure 2 below)
Not only did we get a repricing in the bond market but U.S equities extended losses with the Nasdaq closing Wednesday trading -3%!! An aggressive Federal Reserve means the equity market has even further room to sell off as major markets like the tech focused Nasdaq are caught with the issue of struggling to finance operations due to higher rates but majorly become instantaneously less attractive to investor’s as the present value of their future earnings declines. And for the general wider stock market, higher rates leads to less corporate borrowing, that feeds into lower production of serviceable goods, resulting in lower earnings come earning season. This is the idea of how rising rates affect equity markets as a whole.
From today’s piece we have clarified the hawkish tone voiced from the Fed meeting which sent markets into confusion as a pivot was widely expected; the next question which determines how the global economy will function is something that Jay Powell said within his speech, now that we’ve seen how fast the Fed will move towards a restrictive policy the question at hand is:
“How high to raise our policy rate” and “how long” should conditions remain at a restrictive level?
Two questions that we’ll look to uncover in subsequent pieces.
For those who aren’t familiar with what an inversion in bond yields means, I’ve linked a previous note on the importance yields play within the economy.
Thanks for reading until the end guys!
I won’t lie. This one took me a while! If you enjoyed it please show some love to the thread on Twitter & reshape on Instagram. It’ll only take 20 seconds, unlike this article haha
Until next time
Joe.