Macro Insights: Fed pause playbook Macro Insights: Fed pause playbook Macro Insights: Fed pause playbook

Macro Insights: Fed pause playbook

Macro 5 minutes to read
Charu Chanana

Head of FX Strategy

Summary:  The Fed raised rates by 25bps at the July meeting, and Chair Powell has stayed away from pre-committing any further rate hikes and adopted a data-dependent approach. Markets may view this as a potential end to the Fed’s tightening cycle unless labor market conditions deteriorate. As bond yields fall, there is scope for the valuation laggards of the equity market to catch up. Energy, REITs and renewables may be of interest, but Q4 could bring risks of reflation and recession.

No surprises from the FOMC. A 25bps rate hike to bring interest rates to 5.25-5.50% with a statement that was more or less unchanged from June. Even as Fed Chair Powell tried to keep the case for a September rate hike alive, data-dependency was emphasized far more at the July meeting. We will get two CPI reports and two non-farm payroll reports before the next Fed meeting on September 19-20.

What might the data suggest?

Disinflationary theme has been ruling the markets for now. There are reasons to believe it could be disrupted with base effects weakening in H2. But the Fed will potentially account for that.

As for the labor market, the loosening so far has not been enough to suggest a need for rate cuts, but tracking the unemployment data from here will be far more important to understand when the cycle can turn. Powell noted that full effects of tightening are yet to be felt. He still does not expect inflation to come back to 2% until 2025, but mentioned that if we see inflation coming down credibly, the Fed could move down to a neutral rate level and then below neutral at some point, albeit he pushed back on any rate cuts this year.

Overall, disinflation may not prompt more rate hikes and labor data may not warrant a rate cut, and this suggests we could be in for higher-for-longer interest rates or an extended pause.

What could this mean for investors?

Unless economic data worsens, there may be reasons for the equity market to continue its multiple expansion-driven gains that drove much of the H1 rally. As bond yields fall, there will be the scope for the valuation laggards to catch up. This points to a rotation in equities after much of the H1 gains have been driven by top seven or eight stocks.

Equity sector rotation has been gaining momentum last few weeks, as is evident with gains in DJIA (+3.2%) and Russell 2000 (+4.85%) so far this month outpacing those in S&P 500 (+2.6%) and NASDAQ 100 (+2.1%). While Big Tech earnings have mostly met expectations as of now, investors are looking to find cheaper equity sectors to participate in the rally. This brings up the Energy sector which is the cheapest in the S&P 500 and is regaining traction with the repricing of the US economic risks lower, China stimulus announcements and supply threats. Energy companies are also expanding investments again after years of underinvestment.

A lasting rate pause could also boost the housing sector as it effectively puts a cap on mortgage rates. REITs are particularly interesting in times when economic conditions are strong but central banks are not raising rates. We discussed about the opportunities in REITs in this video. Renewables and electric vehicles are also back on the radar of investors with interest rates reaching a peak, and we expect the risk/reward to be favourable in different parts of the value chain, including battery manufacturers, battery suppliers or charging networks. Our video on EVs discusses stocks and ETFs to get exposure to ride the EV boom. Emerging markets could also get a leg of support from Fed’s pause as they get the room to cut rates ahead of the Fed given faster disinflation, weak demand and higher real rates.

Other considerations for investors

Figure 1: Energy being a key driver of recent US disinflation. Source: Bloomberg, Saxo

Inflation risks cannot be completely discounted, given the rally in commodities is returning and that can bring back goods inflation which has been the major driver of disinflation so far. Real rates will continue to rise from here, either if Fed trajectory gets repriced higher on inflation risks returning. Passive tightening, or the rise in real yields even as nominal yields remain unchanged, is also likely due to the effects of lower inflation. That makes it hard for the valuation driven rally to continue unless equity risk premium is repriced significantly lower. Sentiment and positioning in equities also appears stretched and could be a reason to be cautious.

Figure 2: US real rates (nominal rates minus headline inflation) on an upswing. Source: Bloomberg, Saxo

A Fed pause can also signal a countdown to a recession. There are many risks to keep a watch on, particularly the worsening credit conditions and delinquencies. Q4 growth could see an impact from that, together with a goods reflation and weakness in Europe and China. Adding some duration in fixed income may help investors diversify the risks and navigate a potential recession as well as uncertainty around the Fed’s policy trajectory. If recession risks materialize, long-term US Treasuries will have a more significant upside potential due to their high duration. Gold, which could still remain challenged in the near-term due to the rising real rates (stable nominal rates and decline in inflation) could be of interest again in Q4 if recession concerns accelerate and markets start to bring forward the pricing for Fed’s rate cuts.

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