The expectation here is that the Federal Reserve’s peak aggressiveness will be behind us by mid-2023, with the Fed rate topping at 5.00-5.25%. The Fed’s own projections as well as Fed Fund Futures, that give an insight into the market consensus about the direction of the Fed’s rate, seem to suggest that. This will lead to the next stage of their monetary policy in 2HCY2023. However, the markets are at loggerheads at what that next phase would look like.
Team Restrictive Rates is of the opinion that inflation would stick around for longer, staying above the US central bank’s 2% inflation target. A mix of factors like supply disruptions due to the stretched-out conflict in Europe and on and off lockdowns in China, lingering effects of unprecedented pandemic-era stimulus, multi-decade low unemployment and steady wage growth in the US, and a global transition to cleaner energy are to blame. And given that price stability is the priority right now and not growth preservation, the Fed is expected to pause rate hikes but keep monetary policy restrictive, that is, rates will stay relatively high for long. This will continue to put downward pressure on economic growth as interest rates stay at elevated levels as other central banks follow suit, and risk aversion kicks in globally. This will be negative for equities, positive for accrual fixed income which can capitalize on higher rates and neutral for international gold as higher interest rates and stronger dollar hurt the metal while deteriorating economic conditions support it.
Team Rate Cuts believes there’s a limit to which the Fed will tolerate a growth setback, given that its historical response every time growth has faltered has been to cut rates – think early 2001, 2008, 2019 and 2020. And even if it is ready to let growth slow down, financial stability concerns could force it to pivot. After all, financial stability is the central banks’ implicit responsibility, in addition to its dual mandate of maximum employment and price stability. If financial conditions are kept tight, the vulnerabilities of more-indebted governments, households and corporates could come to the fore. Dramatic declines in financial asset prices which will begin to factor in higher rates and lower growth could spur market volatility and strain market liquidity. This is expected to nudge the Fed and eventually other central banks to act and ease, which will be positive for equities as risk sentiment gets a boost (after a down move of course), positive for long duration debt as prices of higher interest rate bonds rally and positive for international gold prices as opportunity costs of holding the metal come down.
You’ve heard both sides. But don’t fret if you’re not sure which side you want to be on. Things in the real economy rarely shape up as predicted in theory. With so many moving parts – interest rates, inflation and growth and wild cards – the endgame in Ukraine, debt crises in the developing world, unpredictable China, Covid-19, only time will tell which team will win the 2023 round. If there’s one thing though that we can be sure of in 2023 it’s that there’s no escaping the uncertainty and market volatility. As such it would be wise to choose the team which will win no matter what happens – Team Asset Allocation. Hold a judicious mix of assets in your investment portfolio to help you ride out the ups and downs and unpredictability of this year or for that matter, any other.
(Ghazal Jain is the fund manager at Quantum Mutual Fund)
