Pivot hopes dashed
The stock markets have been blushing like cheeks in freezing temperatures. Ever-heating economic growth is forging higher interest rates in front of investors' eyes. Earlier on Tuesday, US stock markets saw their weakest day of the year so far with indices down 2%.
As central banks' dreams of a monetary policy pivot have collapsed, global bond yields have plummeted this year. Bond investors haven't had much fun anyway, as a couple of years of rising interest rates wiped out the last 10 years of total returns, as this Bloomberg Global Total Return Index shows.
In this post, we talk about how recent data shows that economic growth in the eurozone is accelerating. At the same time, interest rate expectations are ballooning, which is not pleasant for equities. This is followed by a brief reflection on how interest rate hikes will perhaps have to go further than expected, as their impact seems to be limited so far.
Eurozone economy in acceleration phase
Fresh Purchasing Managers' Index figures came out of the eurozone on Tuesday, pointing to a pick-up in economic activity in February. For now, investors expecting a recession can keep their grumbling to themselves. The services sector in particular is booming. Demand for financial services recovered despite the downturn in the real estate sector. Demand for IT services also increased sharply.
The eurozone is the most important market for companies listed on Nasdaq Helsinki.
On the manufacturing side, output growth was seen for the first time since last May and elevated price pressures are easing. Overall, however, the manufacturing index is still below 50, reflecting a slowdown in activity relative to January.
The largest economies, Germany and France, also returned to growth after months of malaise. This graph shows the S&P Global composite manufacturing and services PMI for the eurozone paralleled with the change in GDP. These go quite nicely hand in hand and based on this data, eurozone economic growth is brightly positive early in the year.
On the downside, S&P's figure could be raised by tightening price pressures in the services sector and rising wages, which pushed the European Central Bank towards further interest rate hikes. Because of inflation, such juicy economic data may not always be good news, as I pointed out in my Hugger-bugger market post a month ago.
As a side note, in a survey published yesterday by the Ifo Institute, German companies' expectations for the future improved further for the fifth month in a row. This data does not really support the idea of there being a recession.
Indeed, in the wake of strong economic data, market interest rates have risen recently. Germany's 10-year bond, reflecting long-term economic growth and inflation expectations, rolled up to over 2,5%. In turn, the two-year short-end rate, which is more sensitive to central bank rate hikes, has slipped to 3%.
Let's have a quick look at the current rate hike expectations in the market. This should be interesting to those of you with mortgages. The market now expects rate hikes to go up to around 3.7% next summer and stay at that level for a while. So far, expectations have risen steadily higher, but this is the best guess at the moment for interest rate developments.
Interest rate hikes will take a long time to have an impact on the economy
Continuing on the topic of rate hikes, I read a lengthy blog post from the ECB going through the estimates of the impact of monetary policy on inflation so far. Central banks utilize myriad sophisticated economic models whose complexity is overwhelming. If I interpret this graph correctly, a 1% rate hike in the ECB's models should cool inflation by about 0.3 percentage points, depending on the model. Shrinking the balance sheet by €500 billion should bring inflation down by 0.15 percentage points. This would suggest that interest rates may have to be hiked for a while before the impact on inflation really starts to be felt.
The ECB has been hiking interest rates at a rapid pace for just over six months. So far, interest rate hikes are estimated to have cooled projected inflation by just over a percentage point this year, and by almost 2 percentage points next year. At the same time, interest rate hikes, deliberately aimed at curbing economic activity by depressing demand, are estimated to have chipped 1-2% off economic growth in the coming years.
A few more thoughts on raising interest rates, even at the risk of going off the point. Before the current cycle of interest rate hikes, one could often hear in investment discussions that the indebted eurozone or the US could not cope with high interest rates. When the central banks started raising interest rates, which of course also whips up market rates in the short term, there was a lot of stress about whether something was going to break in the system.
So far, the economy doesn’t seem as sensitive to interest rates as previously thought. The damage from monetary tightening has been limited, apart from the real estate sector. The functionality of the bond market has been maintained by injecting liquidity discreetly through the back door, which I have discussed in previous posts.
For example, Ben Carlsson of the Wealth of Common Sense blog made a good point about how years of low interest rates will stimulate the economy for years to come. In the US, households have a total of $17 trillion of debt, of which $12 trillion are mortgages. But presumably the lion's share of these mortgages was previously taken out at a much lower, fixed rate. The Fed's interest rate hikes therefore have no impact on the interest payments of households that have taken out these loans. In addition, the generous public stimulus is injecting wealth into households, whose balance sheets are now flush.
So, it may well be that with high interest rates it will take a very long time to really get to grips with the economy in the way the central bank wants.
In Europe, where the average person is also relatively wealthy, in many countries not that many people even have debt. They will be positively affected by the rise in interest rates, as their savings accounts start to yield something again. Finns also have €112 billion in cash lying in their accounts, which may at some point start to yield a return. It offsets the inflated interest expenditure of the more indebted part of the population at the level of the economy as a whole. In fact, Finns have slightly more cash than mortgage loans (€108 billion in total), according to Bank of Finland statistics.
Eventually something will break in the economy as the interest rate cycle matures, as usually happens, but before then things may look calm on the surface for years. It will be interesting to see how equities are affected by an interest rate environment that could remain high for much longer if these speculations about the economy's resilience to interest rates prove correct.
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