Inflation fears and the Fed

The markets have revised the trajectory of rates

The latest FOMC minutes suggest that “a significant reduction in the size of the balance sheet” may also be needed. The Fed’s policy tightening worries stock market investors for at least three reasons:

First, the Fed’s shift away from supporting growth to focusing on price management likely also implies that the US central bank will be less sensitive to a weaker economic outlook or heightened financial market volatility. This “lower strike on the Fed put” increases the risk inherent in stocks.

Second, investors fear the Fed could push the economy into recession as it tries to hit its inflation target, a worry reflected in an increasingly flat yield curve. An inverted yield curve (in which short-term interest rates exceed long-term bond yields, typically measured by two-year versus 10-year maturities) has
preceded every recession since 1976.

Third, higher interest rates on cash and investment grade bonds increase their attractiveness and could lead to a rotation from equities to bonds if they become attractive enough.

Worries about higher rates may be overblown
History tells us that Fed tightening often ends up leading to a recession. But history also tells us that markets often continue to rally after the Fed begins to tighten. Since 1983, within six months of the Fed’s first rate hike in a cycle, the S&P 500 has gained an average of 5.3%.

Additionally, we have reason to believe that while higher interest rates generally have a negative impact on economic growth, that may not be so true this time around. Higher interest rates generally hurt growth by limiting demand. But in this cycle, demand is already constrained by supply issues and residual restrictions related to the pandemic. So while higher interest rates may affect potential demand, if supply issues ease, economic activity could continue to rise regardless.

Moreover, this Fed under Jerome Powell is hardly a Volcker Fed. Despite headlines of inflation getting out of control, markets expect long-term inflation to remain low even with a relatively modest spike in interest rates. Markets currently expect a maximum interest rate of 2% by the middle of next year to be consistent with average inflation of just 2.5% over the medium to long term (based on inflation expectations over five years). With a real interest rate of -0.5%, this would remain a fairly accommodating policy in absolute terms.

And on valuations, with rising bond yields, equities have indeed become less attractive in relative terms. Yet the yield spread – the inverse of the P/E ratio minus the 10-year bond yield – is still above its long-term average, at 3.6% versus 3.3%. The same is true for the global equity risk premium based on a dividend discount model, at 5.6%
against 4.4%. This suggests that equities are likely to outperform bonds.

Currently, market pricing assumes around six interest rate hikes in 2022 and one to two more in 2023, but it should be noted that investors and markets have historically tended to overestimate consistency and sustainability of rate hike cycles – 1994 and 2009 – 10 are clear examples of this.

If the Fed starts raising rates and inflation starts falling as expected, we could still end 2022 with a Cinderella story of a Fed that went from “behind the curve” to “threading the needle” for balance its mandates of full employment and price stability.

What could cause us to become more cautious?
In our view, one of the main risks is that longer-term inflation expectations start to rise, which would be a sign that markets are beginning to fear that the projected path of interest rates is insufficient to manage the inflationary pressures. This could mean that the Fed has no choice but to raise rates more aggressively, and the increased risk of a Fed-induced recession would prompt us to demand a higher risk premium from equities.

An alternative risk is that longer-term inflation expectations remain contained, but they do so only because the market fears that the Fed will drag the economy into recession with too restrictive a policy. We can monitor this risk by focusing on the shape of the yield curve. If we see short-term interest rates rise significantly above
long-term rates, this could indicate that the market fears an upcoming recession. The spread between 2-year and 10-year US Treasury yields is currently 40 basis points, still in positive territory but the narrowest since August 2020.

For a copy of the full March 2022 “Investment Strategy Guide: The test” report, contact your UBS financial advisor.

This content is a product of the Chief Investment Office of UBS.

About Meredith Campagna

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