Interest Rates: How High and How Fast?

So far this year, the 10-year Treasury yield has risen from 1.52% to 1.93%.? This increase has been accompanied by broadly lower equity markets, with value outperforming growth and international stocks outpacing their U.S. counterparts.

However, investors could be forgiven for being just a little skeptical about this move higher in rates and associated rotation to less expensive equity sectors.? Long-term interest rates have been in a downward trend for more than 40 years.? Fundamental economic conditions do favor further increases in long-term interest rates and the Federal Reserve is sounding more hawkish than in many years.? Still, investors need to consider two critical questions, namely, whether economic conditions will continue to support higher rates and whether the Federal Reserve has the fortitude to engineer them, given inevitable economic and market shocks and potential political blowback.

The Inflation-Plus Expansion

On the first issue, last week’s economic data pointed to continued steady growth with inflation still tracking well above the Fed’s 2% target.?

Crucially, provided another dangerous variant doesn’t take over, the impact of the pandemic appears to be fading.? The number of confirmed cases has fallen from a daily average of 807,000 in the second week of January to just 296,000 in the latest week, while the ratio of fatalities to cases lagged 18 days is running at roughly 25% of the rate in prior pandemic surges.?

Moreover, despite the Omicron surge, PMI data show that both the manufacturing and services sectors grew in January, although at a slower pace than in December.? In addition, light-vehicle sales jumped from an annualized 12.5 million units in December to a seven-month high of 15.0 million units in January.? Heavy truck sales were equally impressive, rising from an annualized 464,000 units in December to 525,000 in January.? The auto industry continues to operate under extreme supply constraints and with very low inventories.? However, it is gradually managing to ramp up production and sales, a trend that is likely to continue all year.?

Leisure, travel, entertainment and restaurants were badly impacted by Omicron in January.? However, high-frequency data show some improvement in air travel, hotel occupancy and restaurant reservations going into February.? Given all of this, we expect to see little change in real GDP in the first-quarter but a roughly 5% bounce in the second quarter and continued steady, although slowing, growth for the rest of the year.?

Importantly, the economic impact of the Omicron surge does not appear to have been severe enough or lasted long enough to change the narrative of an extreme excess demand for labor.

Last Friday’s January jobs report was full of distortions, including major changes to seasonal factors in the establishment survey, significant changes in population estimates in the household survey and the impact of the Omicron surge during the survey week.? However, revised payroll figures showed steady strong job gains of between 400,000 and 700,000 each month since last May.

In addition, other data show a huge 4.4 million gap between the number of job openings at the end of December (10.9 million) and the number of unemployed workers in the second week in January (6.5 million).? Surveys also show that both businesses and workers are very aware of the labor shortage.? The National Federation of Independent Business monthly job survey showed a near-record 47% of businesses having at least one position they couldn’t fill and a 48-year record high of 50% reporting that they had increased compensation.? The January Conference Board Consumer Survey showed 55% of respondents claiming jobs were plentiful in their local area compared to just 11% who said they were hard to get.

Nor is the labor shortage likely to wind down any time soon.? In the January jobs report, 1.8 million people reported that they were not in the labor force due to the pandemic, up from an average of 1.2 million in the prior three months.? However, this is far below the 4.7 million of a year earlier and the return of these workers to the labor force, as the pandemic winds down, can only partially satisfy the current demand for labor.

The worker shortage continues to put upward pressure on wages, with the average hourly earnings of production and non-supervisory workers logging a 6.9% year-over-year increase in January, the strongest gain, (excluding distortions at the start of the pandemic), since 1982.? With quits still running at elevated levels, wage growth is likely to remain strong throughout 2022 and into 2023.

Stronger wage growth will also tend to support general inflation.?

We expect this Thursday’s January CPI report to show a gain of 0.4% overall and 0.3% ex food and energy.? While on a month-to-month basis, this would be milder than in December, measured year-over-year, it would push headline inflation to 7.2% and core inflation to 5.8% both at their fastest pace since 1982.

Year-over-year inflation numbers should ease somewhat over the summer as supply issues diminish and a lack of federal government aid constrains consumer spending.? However, still elevated wage growth along with strong gains in owners’ equivalent rent and higher inflation expectations overall may prevent core consumption deflator inflation from falling below 3% throughout 2022 or 2023.

Can the Fed stay Hawkish?

A long period of steady growth with moderately elevated inflation is the path most likely to produce a sustained increase in long-term interest rates.?

The Federal Reserve has sent strong signals that it intends to raise the federal funds rate from its current 0-0.25% level starting in March and that it will begin to reduce its massive $8.9 trillion balance sheet, starting this summer.?

It is worth noting that before the pandemic, FOMC members thought the appropriate long-term level for the federal funds rate was 2.5%.? Consequently, quarterly rate hikes of 0.25% could allow the Fed to attain that level in just over two years.? However, the Fed’s balance sheet just before the pandemic started amounted to $4.2 trillion.? The last round of quantitative tightening, initiated in 2017, maxed out at a balance sheet reduction of $50 billion per month.? Even at twice this pace, it would take four years to get back to a pre-pandemic balance sheet.

So how rapidly is the Fed likely to move?? The best policy would likely be to raise the federal funds rates steadily by 0.25% each quarter for the next two years and reduce the balance sheet more aggressively, starting in July, ramping up to perhaps $150 billion in monthly balance sheet reduction, including some outright sales of Treasuries and mortgage-backed securities (as opposed to just a passive runoff which would tend to reduce the balance sheet too slowly).? This policy would have the best chance of maintaining an upwardly-sloping yield curve and allowing for a gradual return to positive real rates across all Treasury maturities. This would gradually reduce excess demand in the economy and, importantly, reduce incentives for financial speculation.

However, Fed messaging on this issue is frankly worrying.? At his press conference following the January 26th FOMC meeting, Chairman Powell emphasized that the federal funds rate (rather than the balance sheet) is the Fed’s primary means of adjusting monetary policy.? If the Fed is more aggressive and unpredictable in raising the federal funds rate it runs the risk of destabilizing financial markets.? This could make it more reluctant to engage in aggressive balance sheet reduction.? This, in turn, could lead to a flatter yield curve and concerns that the economy could slow down too much in 2023.?

It is easy to see how this could short-circuit monetary normalization.? Even with core inflation running above the Fed’s 2.0% target, it is doubtful that the Fed would have the fortitude to continue to battle inflation in the face of public or political pressure to ease policy.

And this remains the key impediment in any scenario leading to much higher long-term interest rates.

In 1979, Jimmy Carter appointed Paul Volcker to be Fed Chairman knowing full well that he would battle inflation even if it caused a recession.? The Fed slammed the brakes on the money supply, pushing the prime rate to 21%, triggered a recession and contributed to President Carter being voted out of office in 1980.? However, even when the economy had recovered from the recession, the Fed tightened again, triggering a second and worse recession and with all of that, President Reagan reappointed Volker in 1983!

The determination of the Fed to crush inflation at the end of the 1970s and the acquiescence of two Presidents in letting it do so, speaks both to the respect that Washington had for Fed independence at that time and the public’s fear of inflation.? 2022 is a very different time in both respects and, while this Fed may be turning more hawkish, it is unlikely to prove anything like as aggressive as it was 40 years ago.

If the economy maintains steady economic growth and moderately elevated inflation and if the Federal Reserve has the patience to gradually move short-term interest rates higher while reducing its balance sheet more aggressively, then the next two years could see the federal funds rate move up by 2%, with the 10-year Treasury yield rising by between 1% and 2%, finally returning to positive real long-term interest rates.

However, for investors, it is important to recognize that if, because of Fed impatience, rates rise more rapidly over the next year, there is a considerable risk of a subsequent relapse as the Fed abandons its new-found and still shaky inflation-fighting resolve.? While this still suggests a tilt towards value and international stocks in the short-run, it highlights the importance of being ready to switch back towards longer-duration assets if the Fed abandons its recently hawkish tilt.?

Disclaimer

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.