Curmi & Partners

Hawkish Monetary Policy and Negative Macro-economic Backdrop Persist

By Simon Gauci Borda

This week the Federal Reserve announced its third consecutive 75bps rate increase while also signalling that rates are expected to remain high for an extended period of time. The federal funds rate was lifted to a range of 3.00% - 3.25% with the closely watched “dot plot” pointing to further large increases without any rate cuts expected before the end of 2023. While the 75bps rate hike was widely expected, it was the Federal Reserve Chairman’s comments that was in focus as statements made earlier this week were in stark contrast to comments made at the Federal Reserve’s July meeting.

Last July, Federal Reserve Chairman Powell noted that the U.S. central bank could continue raising rates to tame inflation without tipping the U.S. economy into a recession. However, at this week’s meeting, Powell struck a more negative tone when he noted that the high level of inflation has to be dealt with and that there isn’t a painless way in doing so besides keeping rates elevated with the so-called “soft landing” all but ruled out by economists. The Federal Reserve also published a revised set of economic data with rates expected to rise as high as 4.4% by the end of the current year before  peaking at 4.6% in 2023. This year the unemployment rate is expected to rise to 4.4% while U.S.  economic growth is expected to slow down to 0.2%. Economic growth is projected to reach 1.2% in 2023.

Despite the Federal Reserve’s projections not showing an economic contraction, the market seems to think otherwise given the inverted yield curve which continued to flatten this week following the Federal Reserve’s meeting. In fact, the U.S. Treasury rose to 3.6% on Wednesday compared to the prior day’s close of 3.5% with the yield on the U.S. two-year climbing to 4.1% compared to the prior day’s close of 4.0%.

While higher rates will undoubtedly have a negative effect on fixed income securities given the negative relationship that exists between interest rates and bond prices, the higher rates imposed by central banks will result in higher financing costs for businesses and place pressure on margins and cashflows. As a result, rating outlook downgrades are expected to outpace upgrades driven by the economic and market uncertainty that has set in. While default rates have remained persistently low, several recent downgrades to the CCC rating category have increased the likelihood of further defaults down the line.

Besides the higher rates, other factors are driving the pessimism in markets. Russia’s conflict in Ukraine, the gas supply disruption following the closure of the Nord Stream 1 gas pipeline and the substantial increase in gas prices remain top of mind for investors. The high energy costs have somewhat abated in the last week or so following the decision taken by various European Governments to step in and bring the cost of gas down while also increasing gas reserves for the cold winter months. Furthermore, the Federal Reserve is not the only central bank hiking rates as the European Central Bank recently hiked rates by 50bps with further increases expected while earlier this week the Bank of England and the Swiss National Bank raised rates by 50bps and 75bps respectively.

Credit markets reacted somewhat differently on Wednesday to the Federal Reserve’s decision. European Investment Grade spreads widened by 2bps to 201bps while European High Yield spreads widened by 7bps to 561bps. Furthermore, U.S. Investment Grade spreads tightened by 2bps to 141bps with U.S. High Yield spreads tightening by less than 1bps to 481bps. According to Goldman Sachs, credit spreads are expected to continue widening until year-end given the current negative macro-economic backdrop and hawkish monetary policy expectations. In fact, European Investment Grade spreads are expected to widen to 229bps while European High Yield spreads are expected to widen to 655bps. Goldman Sachs’ forecasts also show that U.S. Investment Grade spreads are expected to widen to 175bps while High Yield spreads are expected to widen to 625bps.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.