Markets and wall street economists now project the possibility of 5 to 7 interest rakes hikes this year with the first interest rate increase expect to come as early as at the next FOMC meeting from March 15 to 16th. Recent market volatility is due to market concerns the FED might raise rates by 50 basis points at the first meeting testing the resilience of the global financial market to the end of easy money.
Asset prices are elevated: the last time, global equities were so pricey relative to long-run profits was before the U.S stock market crashes of 1929 and 2001. Many investor and fund portfolios have crowded trade positions in “long-duration” assets that could be at risk to yield profits only in the distant future. Higher interest could lead to a global re-pricing, especially of “long-duration” assets.
The covid 19 recession has seen the fastest, steepest downgrades in consensus growth projections among all recessions since 1990. That has been the reason why the fed at the start of the pandemic acted as a market maker of last resort, slashing interest rates to zero and promising up to $ 3 trillion to support financial markets and to back-stop wall street broker-dealers and some mutual funds. The Fed is now estimated to be sitting on a $9 trillion balance sheet or 40% of U.S GDP, which is historic and potentially unsustainable. The Biden administration and the Federal reserve are very concerned about inflation because of the outsized impact is having on low-income Americans.
Key risks to the financial markets and the end of cheap money are not only that the Fed is preparing the markets about raising interest rates but reducing their balance sheet at the same time.
We are transitioning from a world based on cheap money asset bubbles and large wealth gaps to a potentially more “common prosperity” post covid as the great resignation and wage inflation could benefit larger parts of the lower-income society.
Due to the pandemic, it was the first time in a recession in 2020 that we had income growth of the general population. Usually, the recession is income reduction. The reason we had disposable income growth, which is both government transfers and your private income, was that the government massively increased transfers starting with the CARES Act in 2020, all the way down through the Rescue Act in 2021, the U.S. saw an enormous fiscal response.
Markets face having the prospect of less if any additional stimulus coming out of Washington, raising the question of whether the investment and global markets cycle is turning. The combination of elevated valuations and rising interest rates against the backdrop of QT (quantitative tightening) could result in large losses for investors. Now is the time to review and stress test your portfolios.
Can we have a Fed that’s raising interest rates, reducing their balance sheet at the same time, without pushing the US economy into recession?
The answer may well be found with the old wall street adage “let the markets guide us.”
Rainer Michael Preiss serves as an investment advisor & portfolio strategist.