Higher for Longer

The month of September lived up to its reputation of being one among the seasonally weak months for the year. The equities and fixed income markets both took the hit as investors factored in increasing probabilities of higher interest rates and for longer. The continued caution in the remarks from the Central Bank officials driven by choppy economic data supported the narrative that expected rate cuts might not materialize as soon as expected by the markets. The nervousness was palpable in markets up until the FOMC’s (Federal Open Market Committee) decision on policy rates and guidance on their forward trajectory on September 20th. The US Federal Reserve decided to keep policy rates flat at 5.50%. However, the dots plot, a chart showing the view of each committee member where the interest rate would be by the end of year, and next few years, suggested the central bank authorities now expected rates to fall back to ~5.25% rather than ~+4.75% as expected earlier (See figure 1), by the end of 2024. Bank of Canada too kept the policy rates unchanged, but kept the doors open for further tightening should inflation not appear to be on track to fall back to their target of 2%.

Figure 1: FOMC Dots Median (June Meeting vs. September Meeting)

Source: Bloomberg

Headline inflation in the US picked up again and was reported at +3.7% year-over-year for August (reported in September), up from +3.2% year-over-year during the previous month. The headline inflation measure in Canada also picked up to +4.0% year-over-year for August (reported in September), up from +3.3% year-over-year reported during previous month. Higher inflation readings put together with caution in central banks commentary further layered on with somewhat better-than expected economic data (which reads through as inflationary or less disinflationary), fed the expectations that interest rates will stay higher for a longer time and consequently, the bond yields jumped across the yield curve on both sides of the border. The yields jumped higher on the longer dated maturities than the short dated, reducing the inversion of the curve in a move known as bear steepener (See figure 2 and 3). Bear steepeners are consistent with expectations of rising inflation.

Figure 2: US Treasuries Curve (Sept 1st to Sept 29th)

Source: Bloomberg

Figure 3: Canada Sovereign Curve (Sept 1st to Sept 29th)

Source: Bloomberg

US ISM (Institute of Supply Management) Manufacturing and Services PMI indices, leading indicators of the US manufacturing and services activity, respectively, are suggesting that services sector is chugging along just fine, and manufacturing sector is getting incrementally less bad. This is at a time when unemployment is still in the range of historic lows and inflation is threatening to rise again. Therefore, should the economic activity pick up again, the risks of wage-price spiral could start to play on Federal Reserve members’ thinking, who have remained steadfast on their objective to bring inflation down to 2%. Better-than-expected economic activity would be a positive for markets provided the inflation readings remain benign and on the right trajectory. However, better-than-expected economic activity along with inflation beginning to pick up again would be a bad sign for financial markets as this implies more tightening might be required.

With that backdrop, we think it is noteworthy that the recent uptick in the US headline inflation has been largely due to the energy component. Driven by production cuts announced by the OPEC+ in June 2023, the crude oil prices jumped by ~+28% during the third quarter, which reflects the jump in the energy component’s contribution to headline inflation (See figure 4). Since food and energy tend to be the more volatile components of the inflation calculations, they can obfuscate the inflation trend in the short term (the core inflation, which excludes food and energy, was steady at +4.3% for the month). We note that weather forecasters expect 2023 winters too be warmer than usual due to El Nino effect, which translates into lower energy demand for heating purposes. Lower demand should put a lid on energy prices and hence its contribution to inflation in the coming months. Furthermore, as outlined in our previous updates, the shelter component of inflation, which constitutes ~35% of the total weight in the inflation calculations has also begun to decline. We think this should help alleviate some of the investor concerns around inflation picking up again in the coming months and help risk assets in the short-term.

Figure 4: Contributions to US Consumers Inflation, month-over-month %

Source: Bloomberg

Over the medium term, we think the bigger question the markets will grapple with is where the inflation will finally settle and if it does not drop back to the 2% level soon enough, how long can economy take higher interest rates without developing major cracks. Should the inflation settle above the targeted 2%, and the economy avoids a recession or experiences only a mild one, the bond yields should stay high as a justification of higher compensation for higher expected inflation. For equities, higher bond yields imply higher equity risk premium, i.e., lower valuation multiple. This will coincide with higher interest rates for longer as central banks will have no justification to reduce interest rates. Higher interest rates for longer only increase the risk of widening cracks in the economy, a risk to be watched out for during 2024, in our view.