Following the Federal Reserve's (Fed) recent rate rise of 0.25% to a new range of 4.5%-4.75%, there's one question on investors' minds – when will the Fed pivot in 2023?
A Fed pivot happens when the US Federal Reserve changes its monetary policy – think interest rates and the money supply. Skyrocketing inflation in 2022 meant the Fed’s pivot towards monetary tightening was well-flagged. It embarked on a one-way path to raise interest rates in the hope of taming price rises.
Markets did not fall as far and fast in 2022 because inflation or interest rate rises were unexpected. Rather, because both turned out to be much bigger problems. Inflation was much higher and stickier than initially forecast, and central banks like the Fed, responded far more aggressively.
Unsurprisingly, 2023 has started with the same two factors foremost on the markets’ mind – interest rates and inflation. Has inflation finally peaked, and will interest rates follow suit? At what level will rates peak? How long will they stay here? When will central banks start cutting interest rates?
These questions matter to investors considering their portfolio and how to invest in 2023, since interest rates and the cost of capital are key drivers of asset prices.
After 450 basis points of hikes from the Fed since March 2022, the market is now expecting US interest rates to peak at 4.9% in June 2023. It then expects rates to start falling soon after that.
Market based US future interest rate expectations
Source: Bloomberg, 27 January 2023.
What’s next for inflation?
Headline inflation is the number that gets most attention, whereas core inflation strips out the most volatile items from the basket of goods – both are starting to moderate across western economies. So, we could see inflation start to normalise quicker than we have in other periods of elevated price increases, such as the 1970s.
Findings from the Federal Reserve Bank of Kansas City supports this view, with its research showing that lags in monetary policy have shortened. In layman’s terms – the time it takes for interest rate hikes to weigh on inflation is shorter than before.
This is largely down to the fact that since the dark days of the 2008 financial crisis, the Fed has employed additional monetary policy measures out of its ‘toolkit’, like forward guidance and its balance sheet.
The consequence of this is that financial markets might react to changes in forward guidance and to the Fed’s balance sheet, before the Fed has actually changed interest rates. Based on their analysis, inflation could start to slow down one year after monetary policy tightening begins. In the US, this was March 2022 and we’ve already started to see inflation come down slightly earlier. This could be the case for other western economies, but of course there are no guarantees.
Long story short, if inflation does fall sharply, there could be a major shift in global monetary policy in the coming months. The market is already expecting this in the US, with approximately 60 basis points of cuts priced in from the peak for 2023. Of course, not everyone agrees, with dissenting voices among some analysts and economists.
Notably, in the UK, the market is expecting the Bank of England (BoE) to reach their peak rate in August 2023. There’s now 22 basis points of cuts priced in from September to December this year.
If inflation falls as expected, and monetary policy is indeed working with a shorter lag, the market could be behind the curve and need to rapidly price in cuts to UK interest rates this year. If this were to happen, this could have a big impact on UK asset prices, and economic growth overall. Cue the ‘whiplash pivot’.
Could the ‘whiplash pivot’ be the good news investment story of 2023?
While we wait to see how monetary policy plays out, whether the Fed pivots, and if the BoE follows suit, there’d another term worth adding to your 2023 investment dialect – the so-called ‘whiplash pivot’.
It could be that a rapid change in monetary policy becomes the good news investment theme of 2023, driving asset prices and sentiment. Beyond keeping an eye on inflation, interest rates and that pivotal ‘pivot’, investors will also do well to keep a laser focus on four other important factors – earnings, valuations, sentiment, and fund flows.
What could be next for stock markets in 2023?
This article isn’t personal advice. If you’re not sure what’s right for you, ask for financial advice.
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