Stock markets rejoiced this week after central banks took turns indicating that raising interest rates to the moon might not be such a hot idea after all.
For investors battered by months of supersized rate hikes, this was an encouraging development. But a bit of caution is in order.
Yes, policy makers are growing nervous about how much damage additional rate hikes could inflict on their economies. Yes, some central banks intend to tighten the screws on borrowers more slowly in future.
But inflicting pain more slowly doesn’t mean the lords of the monetary system are getting ready to pivot and actually reverse the pain they have caused. At best, central bankers are indicating the interest rate hikes they have delivered to date could be nearly enough to slow their economies to the point of stalling and thereby put a lid on inflation. It is difficult to read that as a big positive for corporate profits or for stock prices over the next few months.
Let’s review the evidence. The shift in market tone began on Friday, Oct. 21, when Nick Timiraos, The Wall Street Journal’s chief economics correspondent, reported that the Federal Reserve was heading toward another jumbo 75-basis-point hike in its key policy rate at its meeting on Nov. 2. (A basis point is one hundredth of a percentage point.) No great surprise there. But what was surprising was the assertion that the world’s most powerful bank was mulling significantly smaller hikes afterward.
“Some officials have begun signalling their desire both to slow down the pace of increases soon and to stop raising rates early next year to see how their moves this year are affecting the economy,” wrote Mr. Timiraos, who frequently acts as a conduit for the Fed’s internal rumblings.
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Other well-connected people were busy offering similar perspectives. Ben Broadbent, a deputy governor of the Bank of England, delivered a speech in which he pointed out that market interest rates had moved far above the “optimal response” generated by the Bank of England’s economic model. This was a strong hint that the market might be overestimating how high the British central bank will have to propel interest rates.
The Bank of Canada then surprised markets on Wednesday by bumping up its own policy rate by only 50 basis points instead of the 75 basis points that markets had anticipated. It warned “underlying inflationary pressures remain elevated,” and said its policy rate would probably have to move higher, but noted that economic growth “is projected to essentially stall later this year and through the first half of 2023.”
All of this tells a consistent story. Policy makers seem to have looked back on the pain they have delivered with massive rate hikes over the past few months and concluded they have done most of what needs to be done, at least for now. Interest rate hikes typically take about 18 months to filter through the real economy, so the already-delivered hikes will continue to hammer jobs markets and real estate markets well into next year.
Investors should keep three points in mind as they look ahead.
The first is that a downturn still seems nearly certain before the end of 2023. Eric Lascelles, chief economist at RBC Global Asset Management, pegs the probability of a recession at 80 per cent in North America and at 90 per cent for the euro zone and the United Kingdom.
A second point to remember is that periods of market euphoria can take a while to fully unwind. Investors who only remember the market plunges that followed the 2008 financial crisis or the onset of the 2020 pandemic may think of bear markets as short, sharp episodes. A better parallel to today might be the collapse of the dot-com bubble in 2000. Back then, it took more than two years before Canadian and U.S. stocks finally bottomed. There were plenty of false starts and bear market rallies along the way.
Finally, it’s worthwhile pondering the still murky outlook on inflation. So long as price increases remain well above central banks’ 2 per cent target, policy makers are likely to keep interest rates high.
The Bank of Canada expects inflation to fade back to target by the end of 2024, as do many private-sector economists. Other experts, though, are more skeptical. Jim Reid, a research strategist at Deutsche Bank, pointed out in a note this week that once inflation hits 8 per cent – as it did earlier this year in both Canada and the U.S. – it typically becomes “quite sticky.” History suggests it might be five years or more, not two years, before price pressures finally fade.
If inflation lingers, so will high interest rates. That could pose a headwind for Canada’s highly indebted private sector.
For now, investors should be patient. When will stocks become truly attractive again? When inflation finally begins falling in earnest and central banks begin mulling interest rate cuts, not just slower hikes. We are not there yet.
Ian McGugan