One small step….US interest rates rise

Lift Off! As NASA trundles its newest rocket, taller than the Statue of Liberty, the six-and-a-half miles from its assembly shed to the launch pad at Cape Canaveral ahead its mission to circumnavigate the Moon, the US Federal Reserve (Fed) has achieved lift-off of its own variety this week. As predicted as a racing certainty, albeit three months behind the Bank of England (which also applied a quarter percentage point rise this week, the third since December), it raised US interest rates from ground zero by a quarter percentage point (rather than the half which some forecasters had suggested). For the record, this is the first US interest rate rise since the end of 2018 and the notorious ‘Powell Policy Pivot’ when, over what must not have been his happiest of Christmases, Fed Chairman Jay Powell abruptly terminated the gentle upward trajectory in the US cost of borrowing having been laid siege by recalcitrant markets and beaten up by a tumbling stock market ahead of the festive season. It was an inglorious moment.

 

Fast forward three years and two almost sequential global exogenous shocks, first in the form of a pandemic, and now a major war geographically in the centre of Europe but in one way or another engulfing most of the world, the Fed and other central bankers are confronted with a significant cost-of-living crisis in their national economies. Inflation running at or close to four times the 2% rate allowed for in their shared mandates is being driven directly because of the significant economic dislocation arising from the mitigating actions taken to combat Covid, and now the various sanctions regimes invoked in an attempt to bring President Putin to heel in Ukraine.

Catching the markets on the hop

If the Fed’s current policy shift was well-flagged by the market (remembering that as recently as last summer, Powell was still entrenched in his bunker as economic forces were maneuvering against him to confound his declared strategy that US monetary policy would be stable at least until the dawn of 2024), the hawkish tone of the policy committee meeting was less expected. As economists and analysts start to rein in global economic growth expectations as they join the dots of the complexity of the consequences of sanctions and the corrosive effects of the significant volatility in energy and raw material prices, investors were expecting the Fed actively to tackle inflation, but not so aggressively with escalating interest rates that they would run the risk of killing the economy in the process.

 

Interest rates are a relatively blunt tool with which to control consumer behaviour; empirical evidence suggests that when assessing how heavy-handed or light-touching to be, it usually takes a good 18 months for the effect of a change in interest rates to be measurable in the economy. Ahead of the war, markets had indeed been expecting robust central bank action, ‘pricing in’ seven US interest rate rises this year. However, having been wrong-footed by Putin’s invasion, and rapidly recalculating the assumptions for the outlook, as we mentioned last week, the probability curve predicting the likelihood of further rate rises beyond mid-year had dampened significantly (if a month ago markets were expecting virtual certainty that the Fed would still be raising rates in December 2022, ahead of this week’s meeting that probability had reduced to around 25%). In the event, the Fed’s policy committee conditioned markets to expect a further six rate rises this year and the possibility of three in 2023 to take Fed funds to 2.85% by the middle of next year. Whether such a rate dampens the economy or kills it remains to be seen.

Don’t forget unwinding quantitative easing! 

As we have mentioned many times before in these columns, monetary policy since the Global Financial Crisis which began nearly a decade-and-a-half ago has been dominated not only by ultra-low interest rates but also quantitative easing (QE), the process by which central banks inject liquidity (cash) in to markets by way of buying government bonds, mortgage-backed securities and even corporate bonds too.

 

The path to raising interest rates in such an environment is very logical and very linear: taper QE so as not to frighten the horses; stop it altogether; then raise interest rates. The central banks of the UK, Canada, Sweden and New Zealand all followed this path in 2021. The Fed is doing the same now, and explicitly said that it will be seeking actively to shrink its balance sheet (‘quantitative tightening’) which, in the course of dealing with the pandemic, had doubled in size from $4 trillion to $8 trillion at its peak.

 

The process of executing QE (particularly in Europe where the European Central Bank has been habitually buying more government bonds than eurozone governments have been issuing, thereby actively driving bond prices up) has provided a long-term crutch to all risk markets. That crutch is now being removed and markets must find their own self-supporting levels based on a reassessment of appropriate valuation for those assets; essentially a re-pricing of risk. This will be an evolutionary process though there is the possibility of a more violent reaction if markets are spooked either by another exogenous factor or, losing their nerve, they suffer a bout of valuation vertigo (valuation seldom itself causes markets to crack, that usually requires an external catalyst; valuation tends to determine how far risk asset prices fall before equilibrium is reached).

Oh what a tangled web we weave……

Related to all of the above, markets remain preoccupied with the price of energy. As oil sanctions are invoked (though far from seamlessly) against Russia and its 4% of global supply, so the negotiations continue to try to replace the lost volume. As we intimated last week would be the case, there is nothing straight forward here. Saudi Arabia, the principal OPEC member controlling the biggest taps, is refusing to play ball with Biden. It refuses to talk to him, indignant with the treatment meted out to it by two successive Democrat administrations in Washington, and in particular, the perception in Saudi that Biden’s craven pursuit of a new deal with Iran to contain Tehran’s nuclear capability (a stable from which that particular horse bolted long, long ago) is now inextricably linked to wanting immediate access to Iranian oil, currently the subject of US sanctions. Iran, no friend of the West, is the implacable foe of Saudi, historically a cornerstone Western ally in Arabia whose influence extends well beyond; indeed, Iran and Saudi are effectively locked in a proxy war in Yemen where Iranian-backed Houthi rebels habitually lob missiles on to targets inside Saudi’s border.

 

China too is becoming embroiled. China is a massive net importer of energy (rich but not self-sufficient in coal, it has no domestic oil or gas production to speak of and relies almost entirely on imports). Russia is in danger of losing its international markets. China and Russia, certainly allies if not entirely bosom buddies, are without doubt talking about their mutual strategic energy interests. And, while China denies it, the suggestion that Beijing is contemplating sending military aid to Russia complicates and potentially escalates an already inflamed global geopolitical situation.

No reset button

As peace talks make little progress, even if eventually ‘successful’ (we use that term loosely—‘success’ will bear a high cost with what is currently on the table: at the point of a gun Ukraine has already conceded sovereignty by being beaten to accepting neutrality, and whatever else, the least likely outcome of all is Ukraine emerging as a fully-restored, holistic nation with the identical borders it had on Valentine’s Day), it would be extremely careless to think that geopolitical relations simply return to where we were a month ago and we carry on as if nothing had happened. The ramifications for energy and defence policies, food and supply chain security strategies are profound and the significant reassessment of how they need to be adapted (or as in the case of some national energy policies including Germany and Italy, be torn up and completely re-written) are only just beginning to be appreciated.

 

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