Interactive Investor

How high could US interest rates really go?

7th April 2022 13:00

Graeme Evans from interactive investor

After years of rate cuts and ultra-low borrowing costs, US policymakers are set to announce the biggest hike in over 20 years. Here’s the latest thinking on US rates, inflation at the Federal Reserve’s $9 trillion balance sheet.

Investors held their nerve today despite US monetary policy being on the brink of a rapid tightening and the risks to global economic growth continuing to mount.

The FTSE 100 index stayed close to its opening mark, even though last night’s minutes of the Federal Reserve’s most recent meeting added to expectations for a series of quick-fire interest rate rises as policymakers look to bring inflation back under control.

A measure of their urgency came with discussions about the possibility of starting the reduction of the Federal Reserve’s $9 trillion balance sheet from next month, having been adding assets as recently as last month.

Wall Street is now 80% certain that the Fed will raise rates by half a percentage point to 1% at its May meeting. This would be the first time since 2000 that it has moved by such a large amount and comes amid expectations for a total of 220 basis points (bps) of rate rises this year on top of the quarter point increase from March.

Some policymakers wanted to hike rates by half a percentage point in March but were persuaded not to because of the economic uncertainty caused by the Ukraine war.

At the same time, the invasion and impact of Russian sanctions has dramatically elevated the inflation risks as some economists now think the US consumer prices index could top 8% when the March figure is published next week.

Deutsche Bank analyst Henry Allen said: “It seems to be progressively dawning on investors that this cycle of hikes is going to be very different to the one we saw from 2015, when even at its fastest in 2018, the Fed still only hiked rates by 100 base points in a single year.”

He said there was a case that markets should be pricing 300-400bps this year given where inflation is, highlighting that hikes on that scale were seen in the late-80s and from 1994 with inflation at much lower levels than it is at the moment.

The minutes triggered a big rise in bond yields on both sides of the Atlantic, with 10-year Treasuries up to 2.6% for the highest closing level since 2019. This put further pressure on tech stocks, with Tesla (NASDAQ:TSLA) down 4%, Amazon (NASDAQ:AMZN) 3% and Apple (NASDAQ:AAPL) 2% lower last night.

As interest rate expectations rise, technology and other growth stocks tend to de-rate because the value of their future cash flows has been diminished.

The Wall Street performance failed to result in a weaker session in London, where the recent steady performance means the FTSE 100 index is still almost 3% higher this year compared with 11% lower for the Nasdaq and 6% for the S&P 500.

The outperformance reflects London’s learning towards sectors such as energy and financials, which tend to do well in a period of rising rates.

It also reflects ongoing optimism that the global economy can still avoid a plunge into stagflation, even though the storm clouds are gathering as rising costs put pressure on company margins and household spending power.

UBS Wealth Management’s Mark Haefele does not believe a series of rate rises will tip the US into recession.

The chief investment officer said: “We expect the Fed to hike by 50 basis points at each of the next two meetings. Beyond that, we think it will become apparent that inflation is slowing, allowing the Fed to hike at a more gradual pace.

“Household balance sheets are strong, and we still see momentum from an end to Covid-19-related restrictions.”

Haefele adds that market volatility offers potentially better entry points for longer-term equity themes, such as 5G, robotics, and smart mobility.

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