The authors are CEO and senior consultant at the financial consulting company Complex
The key question in the capital markets today is when the high inflation will be curbed, and how many more interest rate increases will the central banks be required to carry out for this purpose.
The core of the discussion focuses on the USA, where inflation currently stands at 8.2%, but surveys on behalf of the Fed indicate expectations for a sharp drop in inflation already in the coming year. The business survey shows an expected inflation of only 3.3%, while the consumer survey predicts inflation of about 5%, and a decrease in the following years to below 3% – within the target range of the Fed, in the following years.
Effect time of three to four years
Expectations for the fall in inflation, which largely reflect confidence in the actions of the central bank and its determination, are necessary for the success of the fight against it, due to the reduction in demand and the effect of “expectations” on price behavior.
However, in our estimation, there is a high chance that the process of lowering inflation and the high interest rate environment will last longer than expected. The main reason for this is that interest rate increases have a delayed and gradual effect on different layers of the economy. This, in a time frame of years until full effect, and not of a few months, as reflected in the current optimistic estimates.
To illustrate, the International Monetary Fund claimed this month, as part of the global economic forecast, that the peak effect of the interest rate increase on economic growth comes about a year later, and the peak effect on inflation comes within three to four years.
This is due to the fact that the interest rates set by the central bank affect the variable interest loans in the economy and the costs of the new loans. However, many loans carry a fixed interest rate, and they will only be affected when refinancing, over a period of years.
At the same time, higher interest rates do harm the viability of new projects and investments, but existing projects and investment decisions made continue to exist, preserving demand for workers and consumption.
On top of that, companies tend to be cautious about laying off workers, until they feel confident that the economic reality is changing. The lessons of the Corona crisis, in which companies laid off workers when the closures were imposed, but had to quickly rehire less skilled workers, and the existing shortage of workers, especially in the US, are expected to prolong the process.
As evidence, despite the steep interest rate hikes in the US since the beginning of the year, not only was inflation unaffected, but the American economy grew in the third quarter by 2.6%, shattering forecasts for a rapid recession. The labor market also remains stronger than ever: the unemployment rate is at a historic low of only 3.5%, and there is 1.7 Vacancies for every job seeker.
Another illustration of the long process to lower inflation was published by the Economist: countries that have already raised interest rates in 2021, in order to fight inflation, including Brazil, Hungary, New Zealand, Norway and South Korea, have not yet experienced a decrease in inflation, which remains at 9.5% on average.
A similar picture is also presented from a historical perspective. During the high inflation period of the 1980s, the Fed raised interest rates quickly and sharply to about 20% and caused a recession almost immediately, but inflation did not come down until three years later.
The Fed’s interest rate forecasts are also too optimistic
At the same time, the Fed’s interest rate forecasts also seem too optimistic. The Fed expects an interest rate increase to a range of 4.25%-4.5% by the end of the year (from 3%-3.25% now), another slight increase to 4.5%-4.75% in 2023, and from there a gradual reduction of the interest rate in 2024. Many investors even estimate that the Fed will return to the path of interest rate cuts already in the middle of 2023, something that has fueled optimism in the markets in recent weeks.
However, in our estimation, if in 2023 there is still no significant containment of inflation, not only will conditions not be created to lower interest rates, but inflationary pressures to raise them may continue, even beyond 5%.
In other words, many central banks, which may reach in early 2023 close to the interest rate targets they set, but before an actual decrease in inflation, will face a difficult dilemma – whether to continue tightening, or stop for an extended period of time, to examine whether the effect is sufficient. The decision may be required without having sufficient data to assess the effect of interest rate increases on the economy and inflation.
The risk arises from the fact that a decrease in economic activity, such as an increase in unemployment, could create pressures to reduce interest rates even before the drop in inflation has established itself in the economy. On the other hand, continuing interest rate increases, or keeping interest rates too high for too long, due to high inflation figures that do not reflect the trend in the economy, may cause a deeper recession than that required to lower inflation.
A certain bright spot is that, unlike in the past, the monetary policy communication processes are now much more frequent and effective, and include forecasts that affect the markets, which can shorten the period of interest rate increases on the economy. To illustrate, asset prices fell and market interest rates rose this year long before the Fed acted.
Volatility in the stock and bond markets is expected to continue
In our opinion, the optimistic forecasts for curbing inflation are not realistic. The more likely scenario is the continuation of inflation and high interest rates. As a result, the volatility resulting from this will continue in the performance of the stock and bond markets, which may be caught in another wave of declines, against the background of the persistence of high interest rates beyond the current expectations.
The recovery in the stock market may take much longer than what investors have become accustomed to in previous cycles, and be accompanied by many false signals for the return of the increases, to the extent that the inflation figures deceive the central banks and investors.
Corporate bonds may also suffer losses, as many companies will find it difficult to bear high financing costs for a longer period of time than expected, which will harm their profitability and lead some to insolvency.
Another conclusion is that the risk of investing in medium-long term bonds is higher than the prevailing estimate in the market. The expected increase in the Fed interest rate at the end of the year to 4.5% marks for many investors the end point of monetary tightening, in anticipation of significant capital gains with the reversal of the trend. However, the continuation of inflation may force the Fed to continue raising interest rates, to levels that are not within the range of the market’s estimates today.
To illustrate, an increase in interest rates of 7% could cause a capital loss of about 20% in 10-year US government bonds. Therefore, at the present time, it is still preferable in our view to be exposed to a short MHA, which currently yields returns similar to the long MHA, but without the risk of capital losses. This, along with spreading risks to other products, with a short margin and spread as wide as possible, which yield an excess return, even if moderate, with a low volatility risk.
The parties in the article may invest in securities and/or instruments, including those mentioned therein. The aforementioned does not constitute investment advice or marketing that takes into account the data and the special needs of each person