The Bank of Canada and the US Federal Reserve both increased policy rates by 75 basis points during the month of September, bringing policy interest rates to 3.25%. Furthermore, the guidance on policy path going forward continued to indicate a firm resolve towards fighting inflation even at the cost of a recession. As inflation continues to remain stubbornly high, the need to hike policy rates even higher was evident from the Fed’s dot plot chart from September 2022 meeting. Published quarterly, the Fed’s dot plot is a chart that summarizes the views of the Federal Open Market Operations (FOMC). The FOMC committee members vote on appropriate levels of policy rates with each dot representing the vote of a committee member. The latest votes revealed that members increased their estimates of appropriate policy rates from the last quarter and now expect policy rates in the US to be ~4.50% by end of 2022 and ~4.75% in 2023 (See Figure 1), i.e., an additional 125 basis points hike for 2022 and a 25 basis points hike in 2023.
Figure 1: Median Implied Fed Funds Target Rate, %
On top of the tough message delivered by the US Fed chair, Jerome Powell, during the Jackson Hole meeting held in late August, this led the financial markets to reprice the risk assets to the new reality of potentially even higher rates for a longer period. Recall that the Fed chair indicated that there will be a softening of labour market conditions, hardships on households and businesses as the committee moves “purposefully” to bring inflation back to 2%. As concerns resurfaced, the North American equity markets erased the gains made during mid-July to mid-August to make fresh lows for the year during the month. The S&P 500 Index and S&P TSX were down by ~-9.3% and ~-4.6% for the month, respectively. The fixed income asset class suffered as yields advanced across the curve and the yield curve inversion deepened with short-end yields increasing more than the long-end.
The inflation number in the US was at +8.3%, ahead of the expected +8.0% but below the last month’s number of +8.5%. In Canada, the inflation number was +7.0%, below the expected +7.3% and last month’s number of +7.6%. The unemployment rate in Canada inched up to +5.4% from +4.90% last month and in the US to +3.7% from +3.5%. While the inflation numbers remained a disappointment, the rising unemployment provided some respite as it weakened the argument of a wage-price spiral feeding inflation. Looking ahead, the bad news on the economic front could prove to be good news for stock markets. Central banks’ emphasis on the goal to tame inflation by bringing aggregate demand in align with the supply put together with an extreme risk-off sentiment indicates any moderation in economic activity is likely to be viewed constructively by investors. This is because it will indicate that the policy tightening measures are working.
That said, the stock market rallies on such datapoints may be short-lived until they begin to accompany a meaningful softening in inflation numbers. Given that the monetary policy affects the real economy with a lag, the impact of higher interest rates working through the economy should start to become visible in the economic data and the companies’ earnings reports in the coming months. As the incoming data gets incrementally negative, the markets will be looking for cues from the Central Banks on the timing of a potential pivot in the policy path. We continue to believe the ebb and flow of the news; inflation numbers are other datapoints that provide a read through on potential inflation numbers ahead will keep markets choppy in the short-term. Until the central banks begin to drop clues of a potential policy pivot in response to the softening inflation, we think it is prudent to stay invested defensively.