The Rate of Change of Growth and Inflation, Rate Hikes, and the Odds of a Policy Error from the Fed
The Federal Reserve wrapped up its highly anticipated January meeting, teeing up a March interest rate hike and suggesting a potential path of rate hikes that may be more aggressive than markets had expected. The Fed’s hawkish tone sparked a sharp sell-off in stocks and sent Treasury yields soaring.
Source: Wall Street Journal
Though some of February’s rally may have been welcome after a tumultuous month of trading, investors shouldn’t be so fast to take it as an indication that we are in the clear. The market is uniquely focused on the potential for multiple rate hikes the Fed might have in store for the coming year. Elevated inflation rates have some market strategists worried that the Fed is behind the curve.
U.S. consumer prices surged in January by more than expected, sending the annual inflation rate to a fresh four-decade high and adding more urgency to the Federal Reserve’s plans to start raising interest rates. The consumer price index climbed 7.5% from a year earlier, following a 7% annual gain in December, according to Labor Department data released last week.
In our piece FedSpeak, we discussed the Fed’s dual mandate to maintain maximum sustainable employment and keep prices stable.
Given the recent high inflation and a headline unemployment number reportedly under 4%, one might think that the Fed hiking is a no-brainer. However, a lower than pre-pandemic participation rate in the labor force complicates the picture.
Labor Force Participation Rate
Source: St Louis Fed
The images below show that nominal GDP and inflation rates via the CPI Index seem to have hit extremely elevated levels that may cause a casual observer to think it’s the proper time to tighten policy. Recent Year-over-Year changes in GDP and inflation appear much higher than previous trend levels.
US GDP Nominal Dollars YoY SA
Source: Bloomberg GDP CURY Index
CPI YoY Index
Source: Bloomberg CPI YoY Index
While this may seem like a call to action for the Fed, the proper time to tighten policy may have passed because at such elevated levels, the chances of inflation accelerating even further from current levels is somewhat far-fetched. Inflation and growth are more likely to slow than accelerate in at least the medium term.
Meanwhile, one of the market’s favorite recession indicators, the 2s10s spread, which measures the difference between the US Government 2-year yield and the 10-year yield, has been narrowing. When this measure goes into negative territory, it is said that a recession is more likely than not within the next 18 months.
Source: February 2022, St Louis Fed.
The Investment Research Platform, Hedgeye, tracks these changes closely and states:
"We find two factors to be most consequential in forecasting future financial market returns: economic growth and inflation. We track both on a year-over-year, rate of change basis to better understand the big picture then ask the fundamental question: Is growth and inflation heating up or cooling down?"
The graph below shows projections for inflation and real growth as of December 2021:
Graphs above from Hedgeye and Bloomberg depict projections of inflation and growth numbers normalizing to lower, albeit more elevated, from pre-covid levels.
As shown in the chart below, using the World Interest Rate Probability: Rate Path function on Bloomberg, we can see that expectations are for over five rate hikes by Year-End.
So the market data indicates that a Fed Hike may occur numerous times to fight inflation. Yet, there is potential that if the spread between the 2-year and 10-year yield is currently at 58 basis points, hiking rates is likely to put pressure on the 2-year yield to move up since investors expect to be compensated more for tying their money up for two years instead of overnight.
However, if the 10-year yield does not cooperate, the 2-year yield will be in danger of exceeding the 10-year yield, which would amount to a policy error by the Fed.
The recent market volatility shows stocks are sensitive to perceived changes in interest rates.
2018 ended with a series of interest rate hikes that started with Janet Yellen and ended with Jerome Powell.
2019 began with the somewhat infamous “Powell Pivot.” The purported significance of this pivot was that after an extended tightening cycle, aka increases in the Federal Funds rate by policymakers, Jerome Powell stopped raising rates even though he had vowed in late 2018 to keep increasing rates and unwind the Fed’s balance sheet going forward.
After ceasing interest rate hikes in early 2019, the Fed actually cut interest rates in the summer of 2019.
Market commentators viewed the change to cutting rates as being due to the volatility in the equity markets. In January of 2019, CNBC wrote the following:
“Powell was also criticized by market pros for seeming insensitive to the sell-off that took the into a bear market decline of 20 percent on an intraday basis in December. ‘We’re listening carefully with – sensitivity to the message that the markets are sending and we’ll be taking those downside risks into account as we make policy going forward,’ Powell said.”
The change seemed to be more emblematic of Jerome Powell being willing to pivot policies commitments relatively swiftly.
Nevertheless, the Federal Reserve has so far kept steady, as witnessed in the January Fed meeting. Despite inflation metrics reporting at over 7%, the Fed did not hike rates. The Federal Reserve remains patient before starting rate hikes and has shown that more information is needed before the hike cycle can begin.
January 2018, The Guardian. “Janet Yellen sets interest rates one last time. How will history rate her?”
January 2019, CNBC. “Fed chief Powell gave the markets the message they wanted”
February 2019, Grant Thornton. “The Powell Pivot”
The Fed previously stated that it would not raise interest rates until 2023. However, due to the current environment of strong growth and high inflation, the Fed is considering starting interest rate hikes in 2022, even though growth and inflation are projected to slow.
Currently, some projections are calling for five or more separate rate hikes in the coming year. Equity markets have seen volatility, in part, as a result of the interest rate markets’ expectation for ~5 rate hikes this year, as seen in the World Interest Rate Probability tool from Bloomberg.
The expected change in overnight interest rates speculators price in will likely be an important question for equity markets going forward throughout the year. Since the January meeting, expectations have already moved from expecting 1% of total interest rate increases to 1.25%. The spread between the 2-year and 10-year treasury yields will be another important metric being closely watched by market participants.
While we do not know the future, we can look to the recent past in an effort to read the tea leaves. The last time a Fed tightening cycle hurt markets and slowed the economy, we saw the “Powell Pivot” in an effort to avoid a policy error.
However, the Fed is in a tough spot as Wall Street expects inflation and growth to slow. Yet, the market also expects the Central Bank to increase rates meaningfully to slow inflation, especially as the difference between 2 and 10-year treasury yields narrows. Such tough environments to operate in may result in volatility trending higher.
We believe investors may need to brace for yet more volatility. Growth and technology stocks, many of whom are years away from profitability, have been hit particularly hard by investor sentiment regarding announced hikes in interest rates. With rising interest rates comes a hindrance to the potential future cash flows of a business, and a business with high aspirations may have a tougher path to profitability because of the increased expense to their debt financing.
Some active management strategies and, more specifically, alternative investment strategies have historically demonstrated the ability to reduce the overall risk of an investment portfolio. A few areas of opportunities during turbulent market environments may be Relative Value, Distressed and Macro strategies.