When we take a step back and look at the current state of the US economy versus the market’s pricing of Fed policy, it is much closer now than six months ago. But even so, we do not think it is where it needs to be. The labour market is tight, the broader U-6 measure of unemployment which also counts the underemployed and those who have given up looking for work is at 6.9 per cent. This is close to its lowest level in decades, while there are nearly twice the number of job vacancies relative to unemployed persons. Nominal wages are growing at 5.6 per cent year-on-year, notably above the Fed’s inflation target and at their fastest pace in decades.
There is also considerable excess money supply in the US economy. Supply has been growing at about 20 per cent per year following the COVID shock - a function of COVID-related central bank and government stimulus – and a rate of growth never seen before in available data. We believe these dynamics, as well as the consequences of the tragic events in Ukraine (higher commodity prices and supply chain disruption), will continue driving underlying inflation, meaning the Fed has more work to do to fight inflation. We expect the Fed to keep tightening until real long-term interest rates move definitively into positive territory i.e., when US 10-year yields move above 10-year breakeven inflation levels. Given that the Fed believes that the neutral policy setting is 2.5 per cent, this would imply interest rates and the US treasury curve well above that.
Additionally, it is important to remember that the estimate of 2.5 per cent is based on guess work and anchored to the recent past, which may not be entirely relevant because the US economy was in a deleveraging cycle for much of the post-GFC period with an additional headwind from declining working age population growth. Structurally, the US economy appears to be in much better shape having deleveraged, with the possibility of re-leveraging going forward as the largest US population cohort, the millennials, continue to form households. Working age population growth is now also less of a headwind. As a result, there is a real probability that the Fed’s estimate of neutral policy could be too low. Until we see the market measure of US real interest rates turn positive (+0.5 to 1 per cent) and market expectations of inflation (US 10-year implied breakeven inflation rate) beginning to decline, then it is implied that the Fed is not doing enough to rein in underlying inflationary pressures by slowing the economy.
We should also note that there is another major headwind for asset prices; quantitative tightening - or the shrinking of the Federal Reserve’s balance sheet - will have the opposite impact to quantitative easing. While the latter increased the amount of currency in circulation, pushing up the price of relatively finite assets, the former will shrink the amount of currency in circulation, potentially having the opposite effect.
Iain Cunningham, portfolio manager, Ninety One
