Why does a ‘higher for longer’ policy matter for US interest rates?
The US Federal Reserve (Fed) kept interest rates on hold as expected on Wednesday, but the move indicates that US policy makers now anticipate keeping rates higher for longer than previously stated.
This stance, which we anticipated, is driven by the US economy’s recent robust performance, but also the continued lack of satisfactory inflationary slowdown. The service sector, labour market, and underlying inflation are all higher than expected, despite a swift hiking cycle which took rates to their highest level since 2021. Regardless, financial markets are still pricing a quicker start to, and pace of, rate cuts than the Fed has laid out.
Fears of a recession have decreased, with neither the Fed nor market economists signifying this as the most likely outcome. But in our opinion the mostly likely indication of the market’s projection being correct, and interest rates declining quickly, is a US economic slowdown, accompanied by a sustained easing of prices. Some signs of this, including rising credit card and auto loan delinquencies as well as a dip in hours worked and temporary workers are evident, but far from conclusive.
We remain structurally long-term optimists, especially with thematic trends such as 'tech-celeration', driven by AI demonstrating genuine profitability. But, nearer term, the final quarter of the year promises to be an interesting one, with autoworker strikes, the potential for a partial federal government shutdown, and the lagged impact of much of the Fed’s rate increases still likely to be felt.
However, the disconnect in the market view is the main driver of our cautious stance, with the risk of disappointment for the market still higher than we are comfortable with.
The Fed remains inflation focused
The Federal Reserve Open Market Committee (FOMC) has reinforced their US interest rate outlook as remaining “higher for longer”.
This clearly demonstrates the resolve for fighting inflation, highlighted within recent Fed policy maker speeches, remains their core focus. So, US interest rates are likely to be on hold throughout most of 2024, with the rate cutting cycle only beginning in earnest in 2025.
September’s hawkish policy rate hold meant the US central bank kept rates at 5.25-5.50%, but signalled in their forecast, and via the tone of Chairman Powell’s press conference, they expect to deliver an additional rate hike by the end of the year. Given there are only two scheduled announcements left, November 1st and December 13th, both meetings can be considered “live” by the market.
The so-called Dot Plot, the forecasts which accompany the US policy decisions in the final month of the quarter, highlights policy makers expect that US interest rates will end 2024 at 5.00-5.25% – where they are now. This translates into only one interest rate cut in 2024, compared to the three the market is pricing in. This signals a much later start to the rate cutting cycle than was expected back in June, and ultimately what the market is currently forecasting.
This robust US economy still has some cracks
Looking at the economy, US inflation is certainly slowing, and generally quicker than in the rest of the G7. But it still is firmly above the 2% target.
At the same time, US labour market strength has shown a few signs of weakening, such as a decline in the number of temporary workers and a tick-down in the number of hours worked – but this in the context of record low unemployment and robust wage growth.
One early warning sign of stress is that credit card delinquencies are on the rise, but this is coming from a historic low level and mortgage foreclosures remain very low despite the rise in rates. This is understandable given that almost 80% of mortgages are now fixed in the US for at least fifteen years*.
The US service sector continues to be in rude good health: indeed, the Fed’s forecasts show that they expect unemployment to tick up to 4.1% during 2024 and 2025 from the current 3.7%, rather than to 4.5% as previously forecast. However, it is not all plain sailing ahead.
The next test for the US economy will be October’s restart of student loan payments, which have been suspended since the Covid pandemic. This is compounded by the risk of a federal government shutdown which would impact government agencies and cause non-essential functions to halt from October 1st. Also, if inflation fails to come down towards target and just treads water, then the Fed is likely to increase rates even further.
There is also the auto industry strike to consider, with around 125,000 workers on strike over pay and conditions,** which is impacting an industry that accounts for about 3% of US GDP***. All of these hurdles have the potential to hit GDP and in particular consumer spending.
Finally, monetary policy acts with a “long and variable lag”, but even those at the top of Fed can’t agree if this lag is 9-12 months, as put forward by Fed Governor Christopher Waller, or 18-24 months as suggested by Atlanta Fed President Raphael Bostic****.
Why the near-term matters when we’re long-term investors
Longer-term there remains genuine excitement in the market around the economic growth that can be driven by technological innovation, particularly the application of Artificial Intelligence, which for us is an attractive long-term thematic investment opportunity.
But it is key to focus on those firms generating cash, demonstrably profitable, and with sensible valuations. This reasoning provides a stark contrast to the dot-com bubble mania. Near term, while the market appears comfortable in the “lower/sooner” path for interest rates ahead, we retain our view that rates are likely to stay higher for longer.
Our view can occur even if the economy weakens more than anticipated, because the Fed retains its inflation fighting focus. This raises the potential for market disappointment, but without a structural deterioration (a major recession or a significant credit event that isn’t contained, for example) this would almost certainly make equity valuations more attractive and create a compelling case to increase risk.
We’ll be watching closely to see if any of the economic cracks appearing widen, or if this time really is different.
David Semmens, CFA, is the Chief Investment Officer at Cadro and an adjunct-lecturer in finance at Heriot Watt University.
References
* https://www.bankrate.com/mortgages/mortgage-statistics/#type
