Morgan Stanley IM: R.I.P. Cycle, Part 3: Markets, Meet Your (Policy) Maker
Jim Caron, Portfolio Manager and Chief Fixed Income Strategist, shares his macro thematic views on key market drivers.12.10.2022 | 08:01 Uhr
- Risk premia continues to rise as markets price the Fed policy seriously, namely 4.75% by January 2023, with upside rate risk if inflation, particularly wage inflation, doesn’t make sufficient progress to target.
- R.I.P. (Recession, Inflation and Policy Risk) Cycle: The risk of Recession and Inflation are occurring simultaneously, but Policy can only respond to one, not both. If policy chooses to battle inflation, the casualty will be a higher risk of recession. At this juncture it will be hard for policy makers not to make a mistake by either over- or under-tightening, and a mistake can be deadly (R.I.P.)
- Good news is unfortunately bad news, in the sense that economic strength “ups the ante” for more aggressive rate hikes. Mathematically, Fed rate hikes push discounted future cashflow rates higher, lowering the present value of asset prices, the reason for the current down draft in risk assets.
- Higher rates and an increased risk of recession go hand in hand, adversely impacting credit risks and heightening default risks, which in turn widens credit spreads. As both the cost and risk for credit increase, the more likely something breaks in the economy, leading a “hard landing.”
- The “pivot” in policy rates in mid-2023 represents the markets pricing a bad outcome that forces the Fed to stop hiking or even start cutting rates. This is the opposite of what Fed officials are saying, who instead claim they will keep policy rates high for as long as it takes to get inflation to target. And so begins the R.I.P. cycle.
- The labor market becomes a key factor as we try to understand at what “cost” is the Fed willing to pay in order to get inflation, namely wage inflation, to target. That cost is measured by the unemployment rate, which ticked lower to 3.5% on Friday (Oct 7), putting the Fed at odds with the labor market.
- Over the past three months, the economy has produced on average 372k jobs per month. At this this pace, remaining slack will be fully absorbed by year’s end, at which point there will be virtually no one left to hire.
- This is why wage inflation is likely to be sticky, which puts more upward risk on policy rates and that in turn hurts capital. At this point, labor is winning and capital (i.e. asset prices) is losing, in an ever steepening uphill battle.
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