Kambiz Kazemi, Chief Investment Officer
While the Fed’s mandate is commonly viewed as a dual mandate – that of price stability and maximum employment – in reality, the Fed has a triple mandate. Since 1977 it has been mandated by Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates“.
Then why do experts and market participants refer to it as a dual mandate? Mainly because it is often thought that a sound and effective monetary policy, which ensures maximum employment and stable prices, would naturally and automatically result in moderate long-term rates.
In today’s high inflation setting, central banks have been late at raising rates after nearly a decade and a half of easy monetary policy, thus resorting to aggressive hikes which have raised the expectation of economic slowdown and/or recession. This unusual set-up, in our view, makes all three vectors of its triple mandate even more relevant, as the significance of long-term rates becomes as relevant as price stability and employment.
The economic picture in the US is particularly interesting and complex. The US is in technical recession, while inflation has exceeded 9% and very strong unemployment numbers surprised the market on August 5th by bringing the unemployment rate to pre-pandemic lows of 3.5%. So, what scenarios is the economy likely to face?
The important question for investors is how to gauge expectations of what might happen to long-term rates under each of these scenarios. In the case of an economic slowdown/recession one would expect long-term rates to be contained or to drop. However, a tight labor market combined with inflationary pressures due to wage increases and continued Quantitative Tightening does present a reasonable risk for long-term interest rates to awaken and resume their march higher.
After a spectacular rise in the first half of 2022, peaking at 3.5% in June, 10-year US rates have been generally range bound and well behaved. But it is important not to get too comfortable following this relative calm.
Risk management involves keeping all potential outcomes in mind and assigning a likelihood to them while preparing for them. While our view is that the transitory portion of inflation is likely behind us, a view which the market seems to have at least partially embraced resulting in upward price movement for risk assets, the risk for wage increases which we saw as very moderate and contained is now one that we consider far from negligeable.
This in turn brings back the risk of long-term increases to the forefront even if the Fed continues aggressive rate hikes. We are at a particularly treacherous part of the cycle where visibility is very limited and we are likely to be pulled in both directions (both interest rates and equity prices) driven by incoming data, until a trend emerges in the inflation and labor data.
As Chair Powell put it at the May 2022 press conference: “It’s a very difficult environment to try to give forward guidance 60, 90 days in advance”. It has certainty been the case since then and will likely be for a few months to come. It is an opportune time, however, in light of the pull back of long-term rates, to put hedges in place at more attractive levels and to be prepared should the US economy continue to surprise.
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