The Fed is expected to start raising interest rates as early as March and will strive to implement them faster than the markets are pricing today, developments are expected to support long-term bond yields
Guy Beit Or, Chief Economist of Psagot Investment House.
The new year has opened with a storm and there are many developments in a variety of areas whether at the geopolitical level (Russia-Ukraine and Kazakhstan), whether at the economic level or in the markets and of course all of these are closely related to each other.
Still, in terms of markets today there is almost only one game in the city or rather one question whose answer will determine the direction of the coming year and is whether the Fed can raise interest rates and reduce the balance even in a situation where the markets are really unhappy? In a slightly different wording, is that inflation is particularly high and not temporary, can the Fed not raise interest rates ??
So what actually happened here last week? From the Fed protocol, we learned that Fed members are in a “hawkish” mood, especially when the 2022 menu includes not only raising interest rates, but also reducing the Fed balance sheet. It is important to emphasize that in the previous round, when the Fed completed the acquisition plan, it waited almost 3 years in which it maintained a stable balance sheet before starting to shrink, but the reality in 2022 is completely different and the Fed’s sense of urgency to complete monetary expansion and move to a more restrictive policy has never been Greater in light of inflation which, as is already known and clear to all of us, is not temporary and probably much more stubborn.
Over the weekend, we got another justification for that same sense of pressure from the Fed to act soon when the December employment report gave us another very clear signal that the U.S. labor market is in full employment and that the wage pressures in it are just continuing to rise. On the one hand, the increase in jobs surprised down dramatically with an increase of 199,000 (expected to be 450,000), but on the other hand wages completed a jump of 4.7% in 2021, significantly above the expectation of 4.2%.
This combination of a “hawkish” Fed that is very troubled by inflation, coupled with this employment report that only heightened fears that the re-feeding between inflation and wages is growing, has led to increased volatility in markets at the start of the year with a jump in bond yields along the curve. New in stock markets.
In our opinion, the Fed is expected to start raising interest rates as early as March and will strive to implement them faster than the markets are pricing today. However, it is very difficult to give a figure about how many interest rate hikes there will be for the simple reason that we do not know what the Fed’s endurance will be for weakness in the markets.
We are talking about this quite a bit in the current economic cycle, the central banks have entered a trap. On the one hand, raising interest rates aggressively, as is probably required today, could lead to significant weakness in the markets. On the other hand, a slow rise in interest rates will probably not do the job in terms of controlling inflation and a non-rise in interest rates may lead to a loss of confidence in the central bank while a jump in inflation expectations.
Therefore, we assume that the Fed will raise the interest rate as long as the market allows it and in our view, in the current situation the market will not allow the Fed to raise the interest rate as they plan but again, here comes the issue of inflation and direction in 2022. There will be a choice even if the markets do not like it.
The significance for the bond market is complex. An analysis of the yield curve shows that interest rates and inflation have a very significant effect in the short and medium parts, but as we move up the curve, their effect weakens and the effect of the economic situation and stock markets intensifies.
We estimate that bond yields in the short and medium parts of the curve are still likely to continue to climb but with regard to the long parts, there are plenty of question marks – will stock market investors buy the declines in markets or return to long-term bonds? At least in the short term, it is certainly possible that the rise in yields has not yet ended as after the protocol a new component comes into play and that is the possibility that the Fed will actually start selling bonds.
We estimate two developments are expected to support the long bond yields although timing is always problematic. The first development is the economic slowdown we expect to begin to be more clearly reflected in data in the coming weeks, and the second development is our assessment that while the Fed will start raising interest rates as early as March, it is likely to rise faster than currently in the markets. Sooner than expected what will eventually support the long bond yields.
What does all this say about the local bond market?
In terms of inflation, the situation in Israel is still very different compared to what we see in the US and Europe when inflation and inflation expectations are still in the target range. Assuming that inflation in Israel does not jump unexpectedly, the main effect The curve.
However, there are quite a few question marks regarding local inflation and especially we must ask ourselves whether Israel can really evade the inflation that is sweeping the world or has it just been delayed? In our opinion, the risks to inflation in Israel continue to be tilted upwards due to the ongoing disruptions in the production and supply chains in the world, together with the warming real estate market and the wage increases that we believe are expected to increase.
Raising interest rates by the world’s central banks, together with an inflation environment that will at least be in the target area, is expected to lead to our assessment of raising interest rates by the Bank of Israel during the second half of the year, but in the meantime, The Israeli bond market embodies an interest rate hike only in the late 2023 region.