Is This the End of Ultra-Low Interest Rates?

  • Federal Reserve rate hike is a leading indicator for tightening of domestic monetary policy but Australia will lag in this rate hiking cycle.
  • A temporary widening of interest rate differentials favour unhedged international equity exposures.
  • Inflation spikes are noticeable but not alarming as Global Central banks seek partial monetary tightening.

The start of the new year has brought a new focus on what central banks will do next. After years of ultra-low interest rates, central banks seem poised to move to a new regime of rate hikes in order to fight off higher inflation. The US Federal Reserve (Fed) has signalled that they are prepared to fight inflation with as many as three rate hikes to cool persistently high inflation. It’s not solely about inflation though. As we progress through the pandemic, despite new variants creating hurdles, global economies are running hot. Unemployment rates have dropped substantially, most notably in the US and Australia where the unemployment rate in now sub 5% , a level last breached a decade ago. The Fed argues that the economy doesn't need as much support from monetary policy as it once did. While other central banks look set to follow the Fed, for the time being the Reserve Bank of Australia (RBA) may continue to be a hold out.

The RBA expects inflation to stay within target. While Australia has not reported its official inflation numbers since September, the Melbourne Institute of Applied Economics and Social Research expects 4th Quarter inflation to be on the higher side of the RBA’s target band (2 to 3%).

As Central Banks globally increase interest rates, the Australian policy rate is likely to lag behind. Despite some moderation in stance, the RBA has only moved from signaling rate hikes in 2024 to potentially bringing this forward to 2023. The economic data supports bringing the rate hikes forward. Unemployment, which came in at 4.6% in November continues to trend towards the RBA’s 4% target. Acknowledging the improvement, the RBA’s latest policy meeting minutes reflected that the RBA was considering winding up the bond buying program.

While the market is pricing in earlier rate hikes than the RBA is signaling, the RBA’s hesitancy stems from potential headwinds. First, the employment growth is a one-month improvement and it needs to be seen whether it can be sustained. Second, wage pressures are not expected to build before there is a marked improvement in job growth. The current wage growth at 2.2%2 has matched pre-pandemic level, yet this growth cannot be considered as adequate. Additionally, the economy faces challenges from the new Omicron variant.

Broadly, we assess that an Australian policy rate hike will follow global rate hikes but with a lag. Over the last decade interest rate differentials between Australian and the US have been narrowing. Despite the recent widening in the spread between the two, we do not expect this to be a long-term trend. We expect to see Australian rates rise but the timing of any Australian rate hikes would be dependent on Australian employment, wage, and inflation growth. As data continues to flow through, we expect to see a meeting in the middle between the RBA and the market with our expectations currently for potential rate hikes in the second half of 2023.

The potential for rate hikes across markets despite differing time frames has led to concerns about the global economy. These concerns seem excessive at this point in time. The primary reason behind current inflation levels are supply side constraints. These are expected to ease as we move forward, as signalled by Central banks who haven’t put the hard brakes on quantitative easing. The first interest rate hike by the Fed is expected in March 2022. Additionally, the Fed continues with its bond buying program. The timing of interest rate hikes and continuance of bond buying program suggests that inflation concerns are noticeable but not alarming.

The looming Fed interest rate hike has raised concerns about equity market performance. In Figure 1 below we take a look at the S&P 500 and S&P/ASX 200 Indexes’ performances over the last 30 years post recurring Fed rate hikes. We leaned on the Fed rate given the more immediate potential to see rate hikes in the US. Additionally, Australian Policy rate will likely eventually follow the Fed rate to maintain interest rate parity. In the interim, Australian markets will potentially extrapolate upcoming Fed rate hikes to imply a tightening of domestic monetary policy sooner than later.

Given market expectations, we focused on periods with at least 3 concurrent quarters of hikes with the base start date of the assessment being the quarter end that saw the first rate hike. Equity performance was then assessed for both the preceding and succeeding 12-month period. In the last 30 years there were four such periods with at least 3 recurring Fed rate hikes.

S&P 500 Index

The results show that post-rate hike, equity markets in the US and Australia have largely posted positive returns. Post-rate hike equity markets in Australia have largely out-performed pre-hike equity markets.

The most comparable period to today’s environment would be December 2016. This reflects a low starting rate and low quantum of increase. This period saw the Fed rate hiked by 25 basis + for three straight quarters. This was part of US Central Bank’s attempt at tapering. The pre and post equity market performance were not meaningfully different following this rate hike (in both the US and Australia) but were still positive.

We expect equity markets to cope with tightening monetary policy and further Covid related hurdles. Performance of international equity exposures are more likely to be driven by currency movement in the short-term. Widening interest rate differentials between Australia and other countries will put additional pressure on the Australian Dollar that point towards maintaining unhedged international equity exposures. Valuations are also supportive of international exposures with European and Asian equities looking attractive based on price-to-earnings ratios.

Interest rates are one of the many factors that affect equity market performance. Additionally, it will be prudent to focus on the objective for the hike. At present, high inflation and high government spending are a concern and Central banks commentary suggests a gradual tapering and rate hikes. More importantly, there has been a regime change in how Central Banks perceive the markets. They are more accommodative. Pre-1990’s global economies were a high-inflation regime (up to 15% in Australia 1970-19902). Post-1990’s inflation has been subdued (Up to 5% in Australia2). Interest rates formally were a tool to primarily combat inflation. At present, they are used to support the broader economy. High global debt also caps the interest rate ceiling.

We believe that equity markets are robust enough to deal with the partial tightening of monetary policy but we anticipate more equity market volatility in 2022. At the same time, we are cognisant of the fact that any Omicron related hiccup may derail the economic recovery which could then also delay the tightening of monetary policy and provide demand-side relief to inflation.

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