You can’t have a soft landing and a Fed pivot.
Expected Fed funds rates by December 2023
After a dismal 2022, markets are off to a flying start this year. Chinese and European equities are leading the way – the FTSE 100 is close to an all-time high and even some of the epic ‘fails’ from last year’s sell-off are enjoying a decent bounce (Bitcoin +39% and Peloton +59% so far in January).
Behind this rally is a growing belief that we could have a ‘soft landing’. That the recession so widely predicted for 2023 can be avoided or at least delayed. This could happen. Higher interest rates will take time to impact economic growth and China’s reopening is playing a big part in this newfound optimism.
But at the moment it seems as though investors are trying to have their cake and eat it. Markets want to have the cake of stronger growth, whilst also eating the cake of interest rate cuts later this year. In fact they are now forecasting interest rates to be lower in 12 months’ time than they are today.
Crucially, as this month’s chart shows, investors don’t believe what the Federal Reserve (Fed) keeps telling them.
Chairman Jerome Powell and the other Fed members are desperate to restore some of the credibility lost when inflation turned out to be not-so-transitory in 2022. Hence their repeated statements emphasising the need to avoid the mistakes of the 1970s and not loosen policy too quickly. If a recession is avoided, how quickly can the Fed, so concerned about not letting the inflation genie out of the bottle, realistically reverse course?
This looks like a case of cognitive dissonance – believing several conflicting ideas at the same time. The stronger the economy, the stickier inflation is likely to be and the less likely the Fed is to cut rates. But stockmarkets are now assuming an almost impossible trinity of events: better growth and no recession, rapidly falling inflation, and interest rate cuts by the end of the year.
We think this month’s chart represents the defining question for 2023. Who will be right, the Fed or markets? It can’t be both. You can’t have further corporate earnings strength and 2% inflation, you can’t have China reopening and low energy prices, and most obviously you can’t have a soft landing and a big Fed pivot.
Despite their strong start, markets are not out of the woods yet. Enjoy the early 2023 bounce, but the need for protection in portfolios has not disappeared. Remember that markets can be very wrong. Just a year ago they forecast only 80bps of rate rises in 2022 – we ended up with 400bps. Ruffer’s capital protection approach provided a rare safe harbour for investors last year and we think this year’s strong start for equities increases the odds of it proving just as important in 2023.
Originally published by ruffer.co.uk and reprinted here with permission.
