What Now? Three Scenarios for the Fed and Interest Rates

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What You Missed: Long-term interest rates and equities traded lower on the week as the Ukraine-Russia conflict worsened and investors struggled to gauge where the geopolitical situation and financial markets are headed next.  The 10-year Treasury yield had a wild week, trading erratically within a 1.72% to 1.87% range. Once again, most of the action was in short-term interest rates, including 1-month LIBOR, which steadily drifted higher throughout the week. Elsewhere, the price of crude oil leapt about $20 to $115.68, while the US Dollar and Gold both strengthened as investors sought safety in US assets. Treasury yield volatility also leapt to levels not seen since March 2020 at the start of the pandemic.

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Russia becomes increasingly isolated from the global financial system. Sanctions imposed by Western governments in response to the invasion took hold last week, including the planned cutoff of seven Russian banks from SWIFT, the communications system that facilitates global money transfers. Additionally, foreign currency reserves held by the Central Bank of Russia have been frozen, limiting its ability to support a weakening ruble. Index providers MSCI and FTSE Russell announced on Wednesday that they will remove Russian equities from all their indices, effective next week.

Credit rating agencies S&P, Fitch and Moody’s each downgraded Russia’s sovereign rating, putting it in the high-yield category. S&P, after the second downgrade in a week, rates the country just two notches above default. The agencies said Western sanctions call into question Russia’s ability to service its debt. In retaliation for the sanctions, Russia announced capital controls that will block coupon payments to foreign owners of Russian bonds.

A sanctioned Russia increases the threat of a broader war and ensures that volatility of interest rates will be with us until the conflict looks like it’s headed one direction or another. By extension, the blanket of uncertainly covering markets right now means rate caps and other option-based interest rate hedges will remain expensive, but also that we’ll see opportunities for borrowers willing to plan ahead.

Commodity prices soared. Since the start of the invasion, the broad Goldman Sachs Commodity index is up about 16%, to a 14-year high. Oil futures breached $115 a barrel this week for the first time since 2008 as sanctions limited market access to Russian raw materials. Russia has been forced to offer steep discounts on its crude but is still having trouble finding buyers. To the extent that dollar-denominated export revenues become unusable or illiquid, Russia could see less of an incentive to sell energy to the West. Oil prices eased from their highs on Thursday amid reports that Western nations are close to a deal with Iran over its nuclear program.

Our take: The widespread surge in commodity prices and disruption of existing supply chains is exacerbating already high global inflation. One outgrowth of the sanctions is fear that higher global natural gas prices will push up the cost of fertilizers, ultimately resulting in food price inflation and shortages.

Powell signaled that the Fed would hike a quarter-point this month. In testimony on Capitol Hill, Fed Chair Powell all but confirmed at least a 0.25% increase in the Federal funds target when the Fed meets on March 15 and 16. Powell added that if inflation stays hot, the Fed would be prepared to raise more than 0.25% per meeting.

Our Take: It is now all but a certainty that the Fed will raise interest rates by 25 basis points at their March meeting. The billion-dollar question now is how the Russia-Ukraine war affects the Fed’s rate hiking path beyond this month.

Before Russia invaded Ukraine, nearly everyone expected the Fed to soon embark on a long series of rate hikes, and every meeting this year was primed for one. Now that we’re in a highly uncertain economic environment, we suspect that the Fed will proceed with hikes very cautiously as it’s loath to add uncertainty to an already precarious situation.

We suspect that cooler heads will eventually prevail, but that the conflict will linger throughout the year, forcing the Fed to ease off the aggressive hiking plans envisioned by markets – a 50 bps hike in March or a hike at each of the remaining six meetings this year. Given a worsening inflation picture, a slower pace of increases this year means the Fed may have to hike aggressively next year, which could involve multiple 50 basis point hikes.

On inflation specifically, the immediate impact on prices from the Russia-Ukraine war would be for headline inflation to rise. Fed Chair Powell explained last week that the textbook response to an energy price shock is to look through it and that it won’t necessarily “lead to repeated inflation,” implying the Fed still views it as a supply shock that will abate sooner than later. This view takes some air out of any perceived emergency need to hike aggressively anytime soon and solidifies the argument for a 0.25% rate hike this month.

Red hot jobs market won’t change the Fed’s cautionary stance. The always-important jobs market data for February, released last Friday, showed that nonfarm payrolls increased 678k last month, well above the consensus of 423k. Even better, the jobs situation for December and January were revised up by 92k. Other details in the data showed that the labor participation rate rose to 62.3% (vs. 62.2% in January). The unemployment rate dropped to 3.8% (vs. 4.0% prior), better than consensus. Growth in average hourly earnings – aka wages – surprised on the downside, up only 5.1%, substantially below consensus (5.8%), from a downwardly revised 5.5% the previous month.

Our take: Such a strong jobs market amid high and rising inflation means that the Fed just might have gone for a 0.50% hike in the absence of the Russia – Ukraine war. Beyond March, that might be precisely what the Fed will do.

In the meantime, it seems that easing labor shortages might be starting to slow the climb in consumer wages, and therefore their appetite to spend, which provides support to some on the Fed’s rate-setting committee that inflation will moderate later this year. Regardless, inflation remains elevated now and calls for Fed hikes, and soon. We’ll get the first of at least a few this year on March 16th.

What to Watch This Week: Russia’s invasion of Ukraine has upended the outlook for U.S. inflation this year, and Fed monetary policy by extension. Before the war, most expected year-over-year inflation to peak around 7% in March, with a slow but steady fall thereafter.

All that’s changed now. The recent surge in commodity and energy prices, and growing signals that supply-chain bottlenecks are intensifying all over again, likely pushed inflation (via the CPI for February, released this Thursday) over 8%. Another psychologically jarring rise will lie ahead in March’s CPI data, showing inflation peaking near 9%. Inflation will ease eventually but will likely remain near 6% at year’s end, with its trajectory being heavily dependent on geopolitical developments in Europe.

Big Picture: Between the horror of war, the consequence of sanctions, the tail risk of flaming nuclear facilities, and the erratic ebb and flow of economic data, we’re suddenly missing the good old days of simple inflation and supply chain worries.

What’s the worst-case scenario outside of WWIII? It’s if inflation expectations – the opinion on the future inflation rate from different sections of society, including investors, bankers, central banks, workers, businesspeople – become unanchored amid energy price shocks, as happened in the 1970s. In such a case, all bets are off for a slow and calculated Fed after this year, the central bank may have to undertake multiple hikes of more than 25 bps to get inflation back under control, a worst-case scenario that sharply raises the risk of a recession.

While we doubt we’re going back to the ‘70s, we are still experiencing a torrid period of inflation. Let’s call it stagflation-lite. And while inflation should recede this year, it won’t happen fast enough to prevent central banks from quickly normalizing their easy-money policies. That means Treasury yields, which recently surged higher, are going to rise further, at least on the short end of the Treasury yield curve.

Looking to the immediate future, we see three possible scenarios at this point:

  • Best case, the Ukraine fighting comes to a rapid end, peace is restored, Ukraine sovereignty is respected. The conflict fades from the Fed’s radar, and it proceeds with a slow, methodical pace of rate hikes.
  • More likely, the conflict rapidly escalates, and supplies of Russian oil, natural gas and other commodities shrink, driving prices higher for months or even years. The Fed finds itself in a dilemma: The ensuing war-torn uncertainty that smothers economic activity isn’t resolved for months, but the root-causes of inflation worsen. So long as inflation expectations continue to hold, it can temper the pace of policy normalization to cushion the blow to real activity, but the threat to inflation expectations is magnified.
  • In a worst-case scenario, the Russia-Ukraine war bleeds into other, similar scenarios around the globe (e.g., China-Taiwan), encouraging other territorial aggressors to believe that the consequences of invading adjacent territories will be modest. Economic uncertainty surges, and some of the forces that kept inflation at bay for decades (e.g., globalization) are thrown in reverse. Guessing what the Fed is thinking in such a scenario will be the least of our problems, and it’s certain that the monetary policy landscape will be unpredictable.

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Source: Bloomberg Professional