Its Over

...I think it will take a little time for markets to start imputing that the Fed is not going to pivot anytime soon, and Powell said it himself not to expect a rate cut in 2023. Wall St is even infatuated with the notion of a recession hitting soon so the Fed can start cutting rates. So fixated with the dot plot that they could even welcome a recession so the Fed can be get dovish. Be careful what you wish for. But in due time, markets would have to accept a new monetary policy regime of higher rates for longer, and month to month inflation falls ahead probably would matter less now. Because even if inflation drops to 6pc, the Fed is still going to remain resolute.

....the bigger question markets need to ask is how resilient can corporate earnings remain in the quarters ahead in the face of deteriorating demand conditions amidst rates remain higher or longer. That I believe would soon be the key focus of markets. That itself places a cap on how much markets can go higher. Demand destruction would be given steroids and under that condition, commodities is not expected to do well. Even yields won't go much lower from here, and before long all focus would be on Europe entering recession. Gold would need to deal with a more protracted period of no rate cuts. In other words, cash can continue earning good interest for longer, could hamper Gold's attractiveness perhaps even up to another year.
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In his 52-year career in investing, Oaktree Capital Management founder Howard Marks reckons he’s seen two tectonic shifts in markets, or “sea changes” as he calls them.
Now he believes we’re about to see a third. And the rate shock the Federal Reserve delivered on Wednesday night shows why.
That the Fed did exactly what it said it would do on Wednesday night and still managed to leave many investors rattled underscores the difficulty investors are having in processing the end of a 40-year fall in interest rates.

The 0.5 per cent rate rise chairman Jerome Powell announced had been flagged weeks in advance, with Powell and other Fed officials repeatedly telling the market it was time for the Fed to pull back from the 0.75 per cent super-sized hikes that have become the norm this year.

The statement from the Federal Markets Open Committee that accompanied Wednesday night’s rise was equally predictable, with just two words changing from the November version.

But these seemingly dovish moves were accompanied by a series of distinctly hawkish messages.
Rate forecast jump

First was the Fed’s new summary of economic projections, including the famous dot-plot that shows where Fed members think rates are going next.

It showed another jump in the expected peak in rates, with Fed officials now tipping rates will end 2023 at 5.1 per cent, half a percentage point above projections from the previous dot-plot in September.

While these rate projections are really just the Fed members’ best guesses, the new dot plot flies in the face of market expectations in a couple of important ways.

Firstly, the predicted 5.1 per cent terminal rate is much higher than market expectations, which sat at 4.8 per cent on Wednesday and climbed back to 4.9 per cent on Wednesday night.

That suggests Fed members largely ignored the cooler inflation numbers that were released on Tuesday night, and indeed Powell was at pains to play them down during his press conference.

“The inflation data received so far for October and November show a welcome reduction in the monthly pace of price increases. But it will take substantially more evidence to give confidence that inflation is on a sustained downward path,” he said.

The second surprise was that the dot-plot dashed hopes of rate cuts next year if the economy hits a pothole. Fed members do see cuts in 2024, but not huge ones, with the dot-plot suggesting the Fed’s cash rate ends that year at 4.1 per cent.

The message is clear: the Fed is determined to get rates higher than the market expects, and keep them there longer than the market expects, to slay inflation.

Lest any investor still in doubt, Powell used his press conference to hammer home the message.
“Over the course of the year, we have taken forceful actions to tighten the stance of monetary policy. We have covered a lot of ground, and the full effects of our rapid tightening so far are yet to be felt. Even so, we have more work to do,” Powell said.

“Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy doesn’t work for anyone.”
Notably, Powell opened his press conference by noting that the Fed understands that what it is doing is hurting the economy. But he’s equally not shying away from the idea that this is the price that needs to be paid.
The Fed’s projections for the US economy are now essentially recessionary, or stagflationary if you want to take a glass-half-full view.
They now suggest unemployment will take a hit next year, rising about 1 per cent, while GDP growth will hit stall speed, at about 0.5 per cent.
And while the Fed sees inflation coming down sharply next year, officials actually lifted their forecasts for inflation compared with September, underscoring just how far away they believe they are from winning the battle against rising prices.

Wall Street’s confused reaction to Powell’s messages is telling; the S&P 500 dived more than 2 per cent after the Fed hike was announced, recovered to be briefly positive for the session, and closed the day down 0.6 per cent.

That does need to be seen in the context of an 11.5 per cent rise in the index since mid=October, but Wednesday night’s price action shows how desperate markets are for the Fed to pivot back towards rate cuts that might take markets back into a world of central bank support and ever-rising asset prices.
Howard Marks forecasts higher rates for longer

Howard Marks is one who just can’t see that happening. Instead, he believes markets are heading for a new phase that will test the strategies investors have come to rely on during a 40-year decline in global rates.

In his latest memo, Marks explains how his career has been marked by two great “sea changes”. The first occurred not after he entered markets in 1969. At that stage, investors were in love with the Nifty Fifty, a group of big US companies considered to be that rarest of things – high quality and fast-growing.

But the Nifty Fifty were not nearly as impregnable as investors believed, and their prices would fall peak-to-trough by 90 per cent. At the same time, investors like Marks were making strong, stable returns from investing in high yield credit, which until then had been considered more risky than the perceived safety of equities like those in the Nifty Fifty.

“The most important aspect of this change didn’t relate to high yield bonds, or to private equity, but rather to the adoption of a new investor mentality. Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently.”

This mindset of weighing risk and return was turbocharged by the second sea change Marks has seen: Fed chairman Paul Volkler taking rates to around 20 per cent to smash inflation in the late 1970s and early 1980s.
This, Marks argues, ushered in the 40-year decline in rates that would eventually see the Fed set rates at zero in the midst of the pandemic. Now investors with a risk-reward mindset could chase even bigger returns by using leverage.
“The long-term decline in interest rates began just a few years after the advent of risk/return thinking, and I view the combination of the two as having given rise to the rebirth of optimism among investors, the pursuit of profit through aggressive investment vehicles, and an incredible four decades for the stock market.

“It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to overstate the influence of declining rates over the last four decades.”

For Marks, the FOMO markets of 2020-21 now stands as a sort of peak in this trend, the ultimate expression of an ‘asset owner’s market’ and a borrower’s market. With the risk-free rate at zero, fear of loss absent, and people eager to make risky investments, it was a frustrating period for lenders and bargain hunters.”

But as Jerome Powell made clear on Wednesday night, we are now in a very different world of persistent inflation and rising rates.
And where much of the market is betting on – and barracking for – the Fed to get back to cutting rates and supporting asset values, Marks believes there are good reasons the Fed cannot deviate from its hawkish stance.

The first is credibility – having got the idea of “transitory” inflation so wrong, Marks argues it “can’t appear to be inconstant by becoming stimulative too soon after having turned restrictive”.

Second, the Fed needs to win two inflation fights – getting actual inflation down, and killing off any chance that the psychology of consumers around inflation changes. Marks says this will require the Fed Funds rate to be positive in real terms (that is, minus inflation) and even with Wednesday night’s hike, the real rate sits at -1.7 per cent.

Third, Marks says the Fed will want to give itself room to move in the future. “The Fed would probably like to see normal interest rates high enough to provide it with room to cut if it needs to stimulate the economy in the future.”

It’s for these reasons that Marks is anticipating the base interest rate over the next several years will average between 2 per cent and 4 per cent, and not between zero and 2 per cent as it has for the past decade.

“We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more so in the near term. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21.

“And importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.
“That’s the sea change I’m talking about.”