US Fed: A fata morgana hiking cycle?
Figure 5: Financial conditions in the United States and ISM manufacturing index
Our baseline is still a cycle with three rate hikes this year and eight in total. This remains a very moderate normalization path by historical standards. On average, the nominal crunch over the last 50 years of hiking cycles has reached 3.9pp and the actual crunch 2.8pp. For the coming cycle, we expect a tightening to just 2.0 pp in nominal terms and 2.1 pp in real terms. But if growth momentum slows further (e.g. ISM dropping below 50, retail sales still weak like in December, etc.) and we see a noticeable tightening in the MFC, then the Fed could break the tightening cycle after only two or three increases. From today’s perspective, 3-4 hikes should then be priced. The market would move from a bearish flattening to a bullish steepening (Figure 5).
Financial markets are signaling a shortened cycle. The 2y10y slope of the US curve is already very flat compared to previous lift-off phases (75 bps vs an average of 120bps in the 2 months preceding the lift-off). Looking at the forward swap curve, we can already see reversal patterns that previously only appeared in the late phases of hiking cycles, typically 2-3 hikes before the peak (Figure 6). These signals are somewhat at odds with the aggressive prices in the money market, where currently 6-7 increases are forecast for the next two years.
Figure 6: Advance to the reversal point even before the start of the walk cycle
The evolution of the equity markets seems to confirm a shortened cycle. Over the past 50 years, 85% of Fed rate hikes have come at a time when the S&P 500 has been down less than 10% year-over-year. Today we are already at -8.3%. We are therefore approaching an area where rate hikes are very rare (16% of all hikes). When they occurred, it was mainly in the very late phase of the cycle (Figure 7). One can, of course, point to the uniqueness of this post-pandemic cycle and argue that the Fed shouldn’t care about stock markets. However, the past has shown that removing the volatility of risky assets and preserving the wealth effect feeds the reaction function. For us, behind the tactical noise, signals are piling up that the biggest risk in the US bond market may therefore not come from the Fed’s lag on the curve, but many market participants positioning themselves too far ahead of the curve. the curve. As the real economy has gone through a complete cycle in less than 2 years, the markets could go through a monetary cycle without a substantial rise occurring.
Figure 7: Fed rate hike and S&P 500 decline 12
Even over the long term, US yields will remain low. It is difficult to imagine that long rates will recover significantly above 3% in a sustainable way. We currently see the nominal long-term equilibrium interest rate (5 years ahead) in the United States at 2.6%, of which 0.6% is attributable to the real neutral rate. This equilibrium rate could only rise substantially above 3% if we experienced extreme monetary tightening or if massive government spending created a permanent increase in potential GDP. For some, President Biden’s infrastructure plan could trigger such an increase in GDP. However, to double the neutral rate compared to our central scenario, it would be necessary for trend growth to reach around 3.5% (compared to 1.8% currently) without triggering a permanent surge in inflation. But the equilibrium rate could also reach 3% in a negative stagflation scenario.
Figure 8: US equilibrium interest rate scenarios over the next 5 years*
In this case, the driving force would be a definitively unanchored inflation expectation (more than 3%) while the neutral interest rate would decrease because the growth potential is compromised. On a fundamental basis, therefore, it is difficult to substantiate the regime change narrative. It is much more likely that, behind all the current market noise, the lower regime for longer will prevail (Figures 8 and 9)
Figure 9: Scenarios for the US real neutral rate (r*) over a 5-year horizon