In March, we started to get a rehash of the saying ‘the Fed will keep hiking until it breaks something’. And when the banking crisis came along, there were many that thought “yup, that is it”. During that time, inflation was still high and markets were in for a spicy time as the Fed was perhaps forced to rescind its credibility on fighting inflation or stick with its guns and hope that the economy can take it.
They definitely played it right in the end and are they perhaps getting their just rewards? As we head towards the main event tomorrow, US CPI is estimated to fall further in June to 3.1% from 4.0% in May. Does that mean we’re reaching a point where the Fed can start to look towards pressing the pause button? Let’s discuss.
Despite headline annual inflation falling back, core annual inflation is estimated to keep at around 5.0% in June. While much less worrying than last year, there is still some ways to go before reaching the pivotal 2% mark that the Fed is targeting. And that’s not just in the US, it is very much the same case in most developed economies.
So, where does that bring us?
For one, we look to be on the path towards low(er) inflation again but it’s not a certainty either. Most policymakers are just hoping that we can get back to the 2% level by 2025. That’s still nearly two years away.
Until then, the narrative is that interest rates will have to be kept in ‘restrictive territory’ for a prolonged period of time. What does that mean?
It just means tighter credit conditions and generally more pressure on certain parts of the economy, like the housing market.
And if inflation fails to come down significantly, we might be staring at the possibility of stagflation risks – something which the UK is dealing with right now.
The big question for markets then becomes what will come first? Will low(er) inflation come about and major central banks manage to thread the needle and achieve a soft landing? Or will higher rates suffocate the economy and lead to a stronger downturn across the globe and perhaps even see something else break? A hard landing, anyone?
That’s definitely a key consideration when viewing the major themes, not only for the months ahead but also for the year to come. If you’re considering any structural positions in the market, this should be the question you need to ask yourself.
The issue for market players is, there are no easy answers to this at the moment.
Inflation falling is definitely a welcome development for the economy but we’re still not in the clear yet, in saying with absolute certainty that it will head back to the 2% mark. As for the impact of higher rates on the economy, well let’s just say that markets were also caught rather blindsided by the banking crisis in March to April. So, that speaks to the level of awareness – or should I say lack thereof – in identifying what may break next.