Belt tightening

September is proving to be a tumultuous month for investors. Approaching the end of the third quarter and heading into the final three months of the year, the world’s most significant central banks (excepting the People’s Bank of China) have unleashed a torrent of monetary tightening in the form of rate hikes. The problem is inflation, which has come roaring back to life after an extended period of worrying about deflation. For years, central banks had been desperate to push inflation back up to (and even above) their spurious 2% targets, no doubt to help erase their swollen balance sheets and the shockingly high levels of government debt that has been building ever since the Great Financial Crisis 14 years ago.

Mission accomplished – Regrettably

Well, they’ve certainly done it. Inflation, depending on which measure you take, is roughly around 10% for the US, Euro zone, and UK. That’s five times above target in each case. The ‘solution’ to chronic deflation (although for most of us inflation has been evident in equity, property, and bond markets for many years. It just wasn’t picked up by accepted measures like CPI) had been under their noses since 1969 when Milton Freidman coined the phrase ‘Helicopter Money’. Former Federal Reserve Chair Ben Bernanke, speaking as a governor at the Fed, expounded on the theory in 2002. Most people considered the idea little more than a thought experiment back then. But it has since been put into practice. All that was needed was a big enough crisis, in this case the coronavirus pandemic, for central banks to take interest rates to zero, or even negative. Then governments dropped bundles of cash on their grateful citizens. But once the vaccines kicked in and lockdowns ended, nothing was done to reverse these emergency measures. Instead, a generation of stay-at-home day traders was born, while investors piled money into equities, bonds, property, art, jewellery, cryptocurrencies, and even newly invented financial assets like Non-Fungible Tokens (NFTs).

The ‘wake up’ call

Central banks woke up as their inflation gauges perked up. They were forced to tighten monetary policy, removing liquidity from the financial system. After years of benign inaction, they are now moving fast and aggressively. Markets are suffering the consequences. This year has already turned out to be one of the most difficult for market participants. After last year’s string of record highs for the major US stock indices, equities came under sustained selling pressure in January, before bottoming in June and rallying through to August. But since then, stock indices have turned lower again. The trouble is that the rate hikes are coming too late. There are obvious signs that an economic slowdown is happening as Western economies come off the post-Covid sugar high. Unemployment may be low for now, but supply constraints are still apparent, particularly in crucial areas such as semiconductors. Meanwhile, Russia’s war with Ukraine continues to keep energy prices well bid.

Carry on hiking

Over the last week or so, we have experienced a raft of rate hikes from the US and across Europe. The US Federal Reserve has just announced a 75-basis point increase which takes its key Fed Funds rate to an upper limit of 3.25%. US interest rates are now at their highest level since early 2008 when the central bank was cutting ahead of the Financial Crisis. Although it was widely predicted, the 75-basis point hike led to a dramatic sell-off in risk assets and helped lift the dollar to a fresh 20-year high. The reason for the unease was the forecasts which came from members of the Federal Open Market Committee (FOMC) in their quarterly Summary of Economic Projections. The consensus view is that the Fed will push rates up to around 4.6% next year. Not only was this at the top end of expectations, but it was a significant increase from their June forecast of a ‘terminal rate’ of around 3.8%. So, the concern is that rates could go up another 1.25-1.50% before the Fed pauses, with no cuts until 2024 at the earliest. This kind of aggressive tightening in the face of an economic slowdown is raising fears of not just a recession, but of a serious one. Hence the negative market reaction.

What now?

But nothing is written in stone. Changes in interest rates operate with a significant time lag. We could see inflation trend down sharply between now and the year-end, which could persuade the Fed to change tack. That could lead to a sharp bounce in risk assets. But for now, the bears appear to have control and they are closely focused on the stock index lows hit earlier this summer. A sustained break below those levels could lead to a miserable Christmas.