Markets are adjusting to the fact that US interest rates may have peaked, but are unlikely to be cut soon, and investors have sent equities sharply down as they prepare for a “nasty cocktail of deflation”, according to several market participants.
Robert Alster, chief investment officer at Close Brothers Asset Management says: “The US Federal Reserve’s Open Markets Committee (FOMC) voted last week to leave interest rates unchanged.
"The decision to keep the upper bound at 5.5 per cent was widely anticipated but, the committee surprised markets by delivering a more hawkish message than had been expected.
Firstly, FOMC members’ forecasts of where rates will be, known as the “dot plot”, shifted higher. The dot plot now indicates one more hike in 2023, with rates ending 2024 at 5.125 per cent, 2025 at 3.875 per cent and 2026 at 2.875 per cent.”
Alster says this represents a shift higher compared to the last set of forecasts, and suggests that rate cuts will happen only very slowly.
"The Fed’s GDP forecasts also improved, with no marked slowdown in growth now expected," he added.
"The market reaction to the announcement was negative, reflecting the fact that monetary policy is likely to remain restrictive for longer than markets had priced in. This corresponded with declines in bond values, as well as a sell-off in richly valued equities, which have a greater sensitivity to bond valuations.”
Deflation is the economic condition of inflation remaining meaningfully higher than target at the same time that economic growth is negligible or negative.
It presents a problem for central banks because they can usually fix one or other of those problems, but not both at the same time.
Cutting rates to stimulate growth would likely have the effect of making inflation worse, while raising rates to combat inflation would likely have the impact of reducing growth.
Chris Beauchamp, chief market analyst at IG Group says that the Federal Reserve’s decision to pause interest rate rises, but signal that rates will stay higher for longer means that for the first time in a while, "meaningful things are happening in markets".
Beauchamp adds: "What may be different now is that bond yields have risen since the announcement, and that means some of the traditional safe haven equities in the market do not look safe.
But he feels that cyclical assets also look unattractive as rates remaining higher for longer means pressure on household budgets.
"So when you have a situation where both the solid companies and the more cyclical companies are struggling, and stagflation moves nearer. That is upending a lot of assumptions in the market, and that is a nasty cocktail for most investors to deal with, and leaves central banks with some difficult choices to make.”
Tech rally?
Beauchamp says he believes that one of the catalysts for the strong performance of large US technology stocks earlier in 2023 was the assumption that when rates peaked, there would only be a short period of time before they were once again cut.
