The search for neutral

Markets have assumed that monetary policy is now sufficiently restrictive in the US, that growth will begin to subside, and inflation will fall towards target. But what if policy is not yet restrictive and what does it mean for markets if the long run neutral policy rate is higher than currently expected? Our Chief Investment Office explains.

Our view

Over the month of October, bond and equity markets sold off in unison. In the US, the long-end of the curve rose sharply, and the US 10-year Treasury yield broke through the 5 per cent range for the first time in 16 years – even despite heightened geopolitical risks and the potential for conflagration in the Middle East.

Toward month-end, Q3 US GDP printed at a staggering annualised pace of 4.9 per cent and core PCE (the Fed’s preferred measure of inflation) accelerated to a four-month high. Still, despite the strength of the US economy and the unwillingness of inflation to fully succumb to the monetary tightening to date, the Fed stood pat at its November meeting.

While it held the door open for further interest rate increases, market consensus is now subscribing to the theory that the Fed is more than likely done with monetary tightening this cycle.

We don’t necessarily disagree with this view. Monetary policy acts with an inherent lag, and the level of pandemic savings and strength of the US labour market has no doubt held consumers – and subsequently the economy – in good stead since the Fed began raising interest rates in March last year.

Indeed, due to several factors, including these, we believe interest rates have likely only turned restrictive more recently and therefore we expect the US economy to slow meaningfully over the coming quarter. And while inflation remains stubbornly high and the decline in inflation to date is unlikely to continue at the same pace moving forward, leading indicators suggest that price pressures should moderate over the months ahead. Moreover, cracks are beginning to appear in the labour market and key leading indicators here, such as temporary employment – often a precursor to the direction of broader labour market strength – have begun to turn lower in recent months too.

Still, we remain cautious about calling a definitive end to the tightening cycle and believe risks remain skewed to the upside that the Fed and other central banks will need to lift policy rates higher still. Furthermore, as we have been saying for many months now, any end to the tightening cycle doesn’t necessitate the swift commencement of an easing cycle.

Previous tailwinds that have assisted in keeping inflation constrained for the past two decades have dissipated and we maintain belief that we are likely entering a period of structurally higher inflation. This means there is a real possibility that the neutral rate (where monetary policy is neither restrictive nor stimulatory) may settle at a higher level over the longer-term.

Since 2019, Fed policymakers have held a 2.5 per cent median estimate for the long-run policy rate. However, in recent FOMC meetings the central tendency of neutral has risen. If the median estimate ultimately adjusts alongside it, then investors are likely to demand a higher premium for holding longer-term Treasuries and so too equity investors for owning stocks. None of which would bode well for risk assets.

Of course, the neutral policy rate cannot be observed directly, rather it is an estimate and as any economist will tell you, the quest to find neutral is more art than science. Still, the Taylor rule, a model used by many economists to estimate where rates should be based on inflation and economic growth, suggests a Fed Funds Rate closer to 8 per cent is appropriate.

While we are not suggesting 8 per cent is accurate, there remains potential that the strength of the economy has been underestimated and the impact of tightening to date has been overestimated – meaning inflation could reaccelerate in the months ahead and rates would therefore need to move higher still.

This scenario is not our base case, rather a risk scenario. If it was to transpire then yields would likely reach new cyclical highs, any economic downturn would become more meaningful, equities would probably suffer heavy falls and we would expect duration to become a solid diversifier across multi-asset portfolios once more.

Putting aside any potential need for rates to move higher; with growth remaining solid, inflation stubborn and the labour market strong (albeit easing) we struggle to reconcile any potential for rate cuts materialising before the latter half of next year.

Even if the recent pullback in share markets has assisted valuations at the margin and the latest US earnings season looks set to deliver earnings growth for the first time since late last year, yields are still hovering near 5 per cent. While seasonality and bearish sentiment provide scope for brief rallies into year-end, we will likely need to see a sharp fall in bond yields, or a material market dislocation that requires a significant injection of liquidity from policymakers before equities can rally in a more sustained manner once more.

Central tendency is rising

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Source: Fed, Macrobond, ANZ Research

What this means for our diversified portfolios

This month we have upgraded our preference for duration across portfolios and have increased our position in both Australian and global bonds.

With risks rising globally, long-end yields recently hitting 5 per cent in the US and multi-year highs globally, we have elected to lengthen duration across portfolios. Although questions remain about how much further yields may lift from here, over a medium-term horizon we believe duration will once again prove a solid diversifier for multi-asset portfolios. Moreover, bonds are currently providing sufficient carry for portfolios, irrespective of whether we enter a recessionary environment. As such, we continue to believe the risk/reward balance remains skewed in favour of fixed income.

The increases have seen Australian fixed income move to a mild overweight in portfolios from slightly above benchmark previously, and global fixed income has now become our preferred exposure across portfolios, moving to an overweight from mild overweight prior. Both legs have been funded from liquid cash in portfolios.

Overall, we remain positioned defensively, however, maintain a neutral allocation to developed market equities in the event upside surprises and seasonality can prove to be a positive catalyst for share markets over the final months of the year. Moreover, with geopolitical risks rising in the Middle East and some uncertainty surrounding the price of oil, across equities we neutralised our modest underweight to the Energy sector at the commencement of the Israel-Gaza conflict.