The end of easy money

Richard Maparura

Investors around the world should brace for a disruptive tightening in financial conditions. This includes credit, equities and money markets as central banks focus on fighting inflation. On the back of massive pandemic-related stimulus programmes across the world, which kept world markets brimming with cash since the 2020 crash, policymakers are now doing an about-face. As monetary authorities begin to hike rates and pare their balance sheets, a process known as quantitative tightening, investors should be on high alert for the financial repercussions.

The main concern is whether central banks can wean the markets of unprecedented stimulus without disrupting the flow of capital and tipping economies into recessions, and accomplish the so-called ‘soft landing’. The largest economy in the world, the US, has never been able to reduce inflation by more than 2% without inducing a recession. According to Citadel founder and CEO, Ken Griffin, the economic outlook is the most uncertain since the global financial crisis.

Augmenting this view, the International Monetary Fund recently downgraded the world economic outlook for this year and next, citing Russia’s war in Ukraine for disrupting global commerce, pushing up oil prices, threatening food supplies and heightening risks caused by the coronavirus and its variants. Multinational corporations have echoed similar concerns. Apple, for example, highlighted the negative impact that China’s zero COVID-19 policy and the war in Ukraine have had on both demand and supply. Meanwhile, Amazon talked about rising warehouse costs impacting its bottom line.

Recently, the Fed delivered its biggest interest-rate increase in over two decades while outlining a plan to begin unwinding trillions of dollars in asset purchases. It raised its policy rate by 0.50%, and launched its quantitative tightening, with the caps on the value of maturing principal allowed to run-off each month set to quickly ramp up from $47.5 billion in June 2022 to $95 billion three months after.

Bloomberg Economics has estimated that policy makers in the G-7 countries, including the European Central Bank (ECB) and the Bank of Canada will shrink balance sheets by about $410 billion combined in the remainder of 2022 through quantitative tightening. The Reserve Bank of Australia delivered a larger-than-expected rate hike as it lifted the cash rate target by 0.25%, way above the anticipated 0.15% increase. India’s central bank, in its first unscheduled rate change since the depths of the pandemic, increased the repurchase rate by 10%. The Bank of England issued the gloomiest outlook from any major central bank, warning the UK to brace for double-digit inflation and a prolonged period of stagnation, or even a recession, as it raised its official bank rate by 0.25%.

As financial market volatility intensifies, a closer look at the likely financial repercussions becomes imperative. The recent bond market yield-curve inversion, falling real wages as well as declining consumer confidence and real household spending, rising mortgage rates and excessive inventories are all contributing to the volatility. This phase can be viewed as the end of easy money, putting passive investing to the test and possibly highlighting the importance of active investing. To analyse some of the likely implications of rising rates and quantitative tightening, a look at what the world’s most powerful central bank is doing may be a good proxy for implications to the global economy.

Flow of credit

As the Fed aggressively increases rates in an effort to fight inflation, US companies are gradually losing their ability to borrow money at ultra-cheap rates. As borrowing costs continue to surge too high and too fast, the flow of corporate credit may become heavily disrupted. In extreme instances, healthy companies may start to lose access to much-needed funding which would trigger economic havoc. The most widely followed credit gauge is the spread over Treasury bonds that investors demand to hold debt from the largest and strongest US corporations.

Currently, the spread on a Bloomberg index of US investment-grade bonds has risen to 1.35%, from as low as 0.80% in June 2021, signalling higher borrowing costs which can force a contraction in loan growth. A spread above 1.5% signals that credit markets could seize up, making borrowing a lot harder. The metric has proved a reliable red flag in the past after crossing 2% in the volatile years, for instance after the global financial crisis and during the pandemic fallout. This has ultimately prolonged slowdown in commercial and industrial loan volumes, causing historic damage to the world economy.

Valuations

Fears of an economic slowdown, persistently high inflation and an increasingly aggressive tightening rhetoric by central banks have weighed on risk appetite, spurring volatility across financial markets. In the bond market, the aggressive leap in bond yields has led to the worst performance in the Bloomberg US Aggregate Total Return Index since 1980. If these moves in the bond market have not yet fully discounted the Fed’s credit-tightening campaign, there will be room for more volatility. The current P/E ratio on the S&P 500 is 20.25 times, against a historical average of 16.5 times. The current estimate for 2023 according to Bloomberg is at 16.25 times, indicating a possible reversion to the mean.

A common market narrative has been that high equity valuations were supported by ultra-low interest rates, especially for companies with low or no current earnings but the potential to generate higher earnings in the distant future. Valuations will therefore be extremely sensitive to interest rates which discount earnings to determine present stock prices. Higher rates imply lower valuations; $100 in earnings 10 years in the future discounted at 1% works out to $90.5 today, but to only $74.0 when discounted at 3%. The current neutral rate according to the Fed chair is around 2.5% to 3%. As the Fed continues to raise rates, downward pressure will likely persist on equity valuations.

Mortgage rates

Housing is the most interest-rate-sensitive sector of the US economy and rising mortgage rates historically weigh down housing stats. Mortgage rates hit their highest level since 2009 as the upward trend continued in May 2022. The US 30-year mortgage rate is now over 5.25% compared to the lows of 2.80% in 2021. Mortgage payments are claiming a bigger chunk of incomes for US homebuyers, who also have to contend with quickly rising prices. The monthly mortgage bill on a typical existing single-family home with a 20% down payment rose to $1,383 in the first quarter, up $320 from a year earlier, according to the National Association of Realtors. Families reportedly spent 18.7% of their income on loan payments, up from 14.2% in the first quarter of 2021. The pandemic housing rally continues to fuel price growth as buyers battle over a critically tight supply of listings but with rates climbing at the fastest pace in decades, would-be homeowners may delay their searches, putting pressure on global demand.

Strong dollar

The hawkish Fed tone and robust labour market in the US are fuelling the strengthening of the dollar. While the Fed does not directly manage monetary policy for foreign nations, it profoundly affects financial conditions abroad based on interest rate differentials. The ECB and Bank of Japan, for instance, have not increased rates since the pandemic. The Bloomberg Dollar Index, which measures the greenback against a basket of other major currencies, is heading for its biggest gains since 2002.

The Fed dramatically influences global economic activity through its monetary policy. A rising dollar would have significant consequences in particular for emerging markets, which still rely on it to a large extent for their borrowing needs. The stronger the dollar is, the more expensive it is for companies and governments in developing nations to make payments on debt denominated in dollars. The dollar is also being viewed as a safe haven given the current geo-political risks in Ukraine at the moment. As the dollar appreciates, foreign borrowers of US dollars will need more US dollars to service their loans. When borrowers raise the dollars required to meet their obligations, they will cause further dollar appreciation. A global run on the dollar is likely to occur, which will push the dollar significantly higher and worsen problems for dollar borrowers.

Money market

As the Fed starts to shrink its balance sheet by not reinvesting maturing securities, there will be an increase in the inventory of Treasuries and mortgage bonds in search for buyers in the private sector. This may lead to a reduction in the amount of reserves held in the banking system as banks may swap reserve assets for Treasury securities. The main concern for the Fed is gauging the minimum level of reserves required to maintain smooth market functioning. That proved far from straightforward last time, with the Fed inadvertently causing a liquidity crunch in late 2019 that sent money market rates soaring. Banks saw their reserves fall sharply – fuelling a disruptive spike in interest rates on repurchase agreements, a keystone of short-term funding markets. This breakdown caused liquidity headaches all around and forced the Fed to intervene in the funding markets by hastily injecting new liquidity into the system via a series of temporary repo operations and, ultimately, to begin reversing some of the earlier reduction in its securities holdings.

Conclusion

April’s inflation of 8.3% (6.2% core) will probably strengthen the Fed’s resolve to continue hiking rates by 0.50% at the next couple of meetings. The US economy has already contracted by an annualised 1.4% in the first quarter, well short of the market’s expectation of a 1.0% expansion. This decline sets the US up for a technical recession, should second quarter GDP come in negative as well. The stakes are high at the moment and investors should maintain low-risk portfolio positioning until the outcomes of the sharp tightening of financial conditions are clearer.

Richard Maparura is Senior Portfolio Manager, Asset Management, Butterfield

Sources: BCA Research & Bloomberg Economics

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information