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The complex phase the markets are going through, generated by the rare combination of macroeconomic and geopolitical variables, accentuates the guiding role of central banks
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The Fed seems inclined to continue its policy of tightening rates unless one of the following conditions occurs: clear evidence that inflation is falling, a slowdown in the labour market, a liquidity crisis in the system
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A continuation of the rate hike above 4.9% would have further implications for all asset classes: yields (which usually peak just before the end of the rate hike cycle), currencies, commodities, the dollar, gold and equities
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“Don’t fight the central banks”: the adage of financial investors has never been so topical. The complex phase the markets are going through, generated by the rare combination of macroeconomic and geopolitical variables, accentuates the leading role of central banks. It will be important, in the event, to understand when the Federal Reserve signals that the most aggressive phase of the rate hike is behind us.
The quarterly earnings season in the US will help to focus on the maximum level the Fed might reach before becoming accommodative again (the so-called ‘Fed flip’) or at least slowing down the increase. Currently, the level of the Fed flip is estimated at 4.9 per cent to be reached around March 2023. If the quarterly results were well above expectations and if there was reassuring forward guidance on the future earnings, the maximum level could set higher.
Since the cornerstone of the decision-making process seems to be the Fed flip, let’s see what this could be determined by. There are three conditions that could lead the Fed to pause the rate tightening phase.
1) “Clear and convincing” evidence, these are the adjectives used by Fed Chairman Jerome Powell, that inflation is falling. An initial interpretation of the statement indicated the signal in a Personal Consumption Expenditures Price Index (PCE) at 4%. We believe that a steady monthly movement towards this level may be sufficient.
2) A slowdown in the labour market. Rising unemployment, or fewer jobs available, or an increase in claims for unemployment benefits, would indicate a slowdown in inflationary pressures.
3) A liquidity crisis. If the liquidity of the system, starting with that of the Treasury, deteriorated to such an extent that it became difficult for firms to refinance their debt, it would be clear that there were cracks in the proper functioning of the market: at that point the recovery of financial stability would require accommodative central bank intervention (as happened recently in the UK).
In addition, it is our view that a wise monetary policy should wait for the effects of three or four major increases, such as those made so far, before continuing with such aggressiveness. We believe, however, that if one of these three conditions does not materialise, the Fed will instead continue to raise rates with heavy implications for all asset classes. Bond yields usually peak shortly before the end of the rate hike cycle. This will also have implications for currencies and commodities, especially the dollar and gold.