• Fed continues to raise interest rates to fight inflation
• Investors are hoping for the end of the rate hike cycle
• Citigroup strategist warns of unpriced rate hike to six percent
After inflation rose to dizzying heights last year, the US Federal Reserve, which had initially assumed that the rising inflation was only a temporary phenomenon, finally took heart and started to turn around interest rates. In order to get the high inflation rates under control, the US key interest rate has now been raised eight times since March 2022, so that it now ranges between 4.5 and 4.75 percent. However, the most recent rate hike at the beginning of February, with an increase of only 25 basis points, was again significantly lower than the times before.
The Fed’s actions are already having an effect: inflation in December 2022 was 6.5 percent, after 7.1 percent in November, 7.7 percent in October and 8.2 percent in September of the same year. Accordingly, the market is hoping that the rate hikes could soon be over. Some optimists even hope that the first interest rate cuts could be implemented this year.
Fed insists on further rate hikes
Fed Chairman Jerome Powell only emphasized at an event in Washington at the beginning of February that further interest rate hikes were necessary in order to push inflation further towards the central bank’s declared 2 percent target. As the currency watchdog expects, this should not be achieved until 2024. In addition, the US labor market would continue to show great strength. If this stays that way, it is conceivable that the peak of interest rate hikes will be correspondingly higher. The market is currently assuming that interest rates will peak at just over five percent.
The reason why the market is not expecting higher rates is the concern that higher interest rates could plunge the US into a recession. However, Fed Director Michelle Bowman recently said at an American Bankers Association event in Orlando that a “soft landing” for the economy is still possible despite higher interest rates: “We are still a long way from achieving price stability. And so am I expect that it will be necessary to tighten monetary policy further to bring inflation towards target,” said the Fed senior official.
Citigroup warns against too much optimism
The prospect of an imminent peak in interest rates has led to large gains in equity markets in recent weeks. The market-wide US index S&P 500 has already gained 8.02 percent since the beginning of the year (closing price on February 15, 2023). However, according to Citigroup strategist Mohammed Apabhai, this premature optimism could have devastating effects on stock and bond markets. In his opinion, investors would ignore the possibility of how the markets would react to an interest rate hike to a level of six percent, after all such a range has not yet been priced in. Should this scenario materialize, however, there could be a bloodbath in the stock and bond markets.
This is how low stock and bond markets could fall
The stock markets in Europe, Hong Kong, South Korea and the USA are now overpriced, which means that they will fall in the next three to four months. The fair value of the S&P 500 would fall below 3,500 index points this year. The Hang Seng is also likely to fall, giving up its gains since the start of the year. For a bullish scenario on the stock market, the US dollar would have to fall another ten percent, but this is hardly conceivable “if the Fed raises interest rates to a level that the market does not expect”. Instead, Citigroup is currently seeing signs that the US dollar has bottomed. Even a small rebound in the US dollar could mean major headwinds for the markets. He even went so far as to suggest that the rally in the Hang Seng since the beginning of the year (+5.21 percent) had less to do with the reopening of China after the strict corona policy and much more to do with the falling US dollar. What he therefore recommends to clients is to sell in the wake of stock market rallies.
But the bond markets are also facing large discounts. “I think the yield curve is frankly wrong. The bond market is too dovish. But the bottom will only come after an extreme point on the hawkish side. The market hasn’t factored that in yet,” said Mohammed Apabhai. In his opinion, it is premature to stock up on bonds with a ten-year term. This is only appropriate with a return of more than 4.25 percent. He also believes that an accelerated pace of quantitative tightening could fuel the US dollar, which in turn should weigh on emerging markets. Citigroup therefore currently advises against Chinese government bonds or bonds from the Asian emerging market.
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