With high inflation and central bank rate hikes, why are financial markets pricing in interest rate cuts?

By Gareth Vaughan

Markets and prices for a number of asset classes are currently behaving as they tend to behave during a recession, says BNZ interest rate strategist Nick Smyth.

Speaking in the latest episode of interest.co.nz Podcast of interest, Smyth also said that financial markets are pricing in Federal Reserve rate cuts as early as next year, despite the Fed’s current aggressive hike and US consumer price index (CPI) inflation growing higher. of 9%, suggest that the markets are worried about the risk of recession.

“The market has seen about 90 basis points of rate hikes over the past three [Fed] meetings this year, so the Fed continued to hike quite aggressively for the rest of this year. And then next year he’s planning just over 50 basis points of rate cuts, with the first rate cut being fully priced in by June,” Smyth said.

“So why is that?”

“The logical way to interpret it would be to say that the markets are worried about the risk of recession. And I guess you can see the evidence of that in various parts of the financial markets,” Smyth says.

“So, for example, the S&P 500 is down more than 20%. It’s that definition of a bear market. Bear markets are often, but let’s be clear not always, associated with a recession. The yield curve is inverted, which has always been a fairly reliable leading indicator of recession.”

“We have industrial commodity prices like copper, and copper is kind of used in a lot of different things [and] historically, this has been a fairly good barometer of the strength of global demand. And that was down over 30% from its peak,” Smyth says.

“So you have a number of asset classes that behave as they normally would before or around recessions. And that’s happening in the context of central banks very aggressively raising interest rates over a short period of time, and in a fairly synchronized manner.”

Excluding China, which has its challenges around zero-Covid, and Japan which still has relatively low inflation, Smyth notes that even the European Central Bank is raising interest rates, having not done so in 10 years. .

“So a cycle of synchronized global tightening will certainly slow down [economic] growth. And then we have these other contributing factors that are worrying the markets about the growing risk of recession, including the risk of lockdowns and restrictions in China, and the situation in Europe where you have potential gas shortages and rationing of electricity later this year.”

“So I think the asset markets are kind of telling you that there’s at least a reasonable, if not high, probability of a recession next year. And historically, during recessions, the Fed cuts interest rates interest.”

The Fed raised the federal funds rate, its equivalent of the official cash rate (OCR), by 75 basis points to a range of 2.25% to 2.50% July 27. Smyth says markets see it peaking between 3.25% and 3.50% in the current tightening cycle. And they see the OCR, currently at 2.5%, peaking between 3.75% and 4%.

“And the New Zealand market now reflects the same profile as the US, so there are rate cuts, but not as much as in the US, which is also priced into the short end of our curve” , says Smyth.

Meanwhile, Smyth says markets see US CPI inflation, currently at a “surprisingly high” annual rate of 9.1%, dropping to around 7.5% by the end of the year. , then fall to around 2.7% by the end of 2023.

“So that’s a really big drop. And again, that’s consistent with the market thinking there’s going to be a recession or some kind of miracle with global supply chains,” Smyth says.

In the podcast, Smyth also talks in detail about this week’s market reaction to the Fed’s rate hike, what the yield curve is telling us right now, the Reserve Bank’s quantitative tightening and the Fed, or measures to reduce liquidity or money supply in the economy, and expectations for Wednesday’s Labor Force Household Survey from Statistics NZ, and what that will say about the labor market.

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