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Many investors were left feeling uneasy as the first quarter of 2022 ended. US inflation remained a hot topic, and the general sentiment around the economy's robustness was uncertain. Many concerns were centred on whether the economic environment was suitable enough to withstand the US Federal Reserve’s plans of rate hikes throughout the rest of 2022. Once again, there is a lot of noise, and to get some sense of direction, we need to look at the unbiased evidence and base our economic views on these instead.

The initial concern going into 2022 was the sky-high US inflation, which at the end of the quarter sat at 8.5%. The Fed announced the first interest rate hike of the year at the first Federal Open Market Committee (FOMC) meeting and Fed communication indicates that restrictive monetary policy will persist until at least 2024. This includes further rate hikes at each of the remaining six meetings of the year and the unwinding of the Fed’s balance sheet. Balance sheet unwinding means the Fed will begin selling primarily longer-dated treasury bonds, which means longer-dated bond yields would go up.

With higher attractive bond yields, sovereigns with current account surpluses will likely buy US treasuries. Rising backend yields affect mortgage prices (inversely) and property financing. The reason inflation remains elevated is in part due to higher mortgage prices and property financing. Automobile financing is also fixed at the five to six-year interest rate tenor. The point we are trying to make here is that neither of these is entirely dependent on the short-term policy rates, but they do impact inflation. 

By breaking down the Fed’s balance sheet, Mortgage-Backed Securities (MBS) make up a significant portion – this means that the Fed has the capacity to sell MBS, which puts upward pressure on MBS rates. This, in turn, puts upward pressure on mortgages as mortgage holders will also start selling as they must now pay higher interest. The result is a cooling of the economy without the Fed having to actively hike short-term rates. 

Although the US unemployment rate of 3.6% is the lowest since the start of Covid-19, wages are not rising as fast as inflation. However, this indicates that there is no wage-price spiral yet, and inflation expectations are not very high. The Fed has a dual mandate to attain full employment and price stability – the first has been overachieved.  

We think that the Fed is acutely conscious of the high inflation that persists, but are also aware of the lagged impact that a tighter monetary policy can have. Our view is that they are not hiking because inflation has just reached 8.5% now, but because the economy is currently strong enough to do so, with big balance sheets and low unemployment prevailing. This signals that the Fed wants to slow down the economy to avoid overheating in 12 months time and potentially ending up with a wage-price spiral. In reality, we must remember that even though the headlines might say that inflation is at “the highest since December of 1981” and that the Fed must hike immediately, the Fed has a longer-term view on inflation and will not just hike because of where inflation currently sits.

We see more evidence as to why the environment will accommodate the Fed’s rate hikes by comparing our estimate of the Laubach Williams Natural Real Rate (where monetary policy is estimated to be at a neutral point) to the actual real Fed funds rate. If the real Fed rate is below the Laubach Williams estimate, interest rates may rise and vice versa. In the chart below, the current real Fed funds rate is far below our estimate of the Laubach Williams. This suggests that the Fed has sufficient room to hike rates and shows that they could have started hiking rates in early 2021.

Source: Prescient, Bloomberg, US Fed as at 21 April 2022

** The San Francisco Fed discontinued the calculation of the Laubach Williams estimate, but we were able to extract the code and continue the series.

At Prescient, we do our best to make sense of the noise. Our in-house Prescient Economic Indicator gives us an understanding of the overall trend in the economy. It is a statistical model that considers a wide range of data releases and outputs a single number that reflects the state of the economy at any given time. At present, the US PEI is still above the long-term median line but is slowing down quickly. This suggests that we are out of the Covid post-recovery stage and are now reverting to “trend” growth – not that we are heading for a recession. 

Source: Prescient, Bloomberg as at 21 April 2022

We are admittedly in uncertain times, but what is important is not to be swayed by the noise and to rather be informed by unbiased data and facts. Sure we cannot predict exactly what will happen in the next quarter, but what we can do is adjust our positions according to what is currently happening and bring it all together in an unbiased, systematic framework. DM/BM

Author: Shriya Roy – Quantitative Analyst at Prescient Investment Management.


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