The intensification of market conviction on the US Federal Reserve backing off from its avowed restrictive stance has been the driver for the risk markets across the world, including India. This sentiment reflects in the recent revival in global commodity prices and a rebound in global equities.
However, the glaring conundrums.
The Fed fund futures markets are pricing in a peak rate of 4.75 percent by September 2023 and 4.30 percent by December 2023 contrasting the average of 5.25 percent in the Fed’s dot plot and a median of 5.1 percent. Consequently, the dollar index weakened by 11 percent, partially reversing the 26 percent rally earlier, amidst a rebound in commodity prices and equity valuations edging upwards. These contradicting assumptions are challenging the Fed’s guidance of sustained tightening to a restrictive regime.
Assessment across asset classes viz. rates, equities, house prices, and commodities, in the context of the tight labor markets and strong consumption demand, suggests that the Fed tightening thus far hasn’t been enough, and the desired restrictive stance has not been achieved.
Asset price deflation plays a crucial role in the transmission of monetary tightening aimed at taming inflation. But this transmission has been less effective thus far and is reflected in numerous indicators.
First, the premature rebound in commodity prices has implied all commodity prices are higher by 18.5 percent on 3-year CAGR. This would diminish Fed’s earlier comfort on one of the three key variables; the other two are high wage growth and services inflation.
Second, with unemployment rate dipping back to a 50-year low of 3.5 percent, the tightness in the labour market has sustained with labour compensation growth remaining high at 6.2 percent YoY.
Three, house price index is still 45 percent higher than pre-covid despite the initial slackness in activities.
Four, since the valuation of asset prices have corrected modestly, the net-worth to disposable income ratio of households remain high at 7.3x and is feeding into leveraged consumption.
Fifth, real consumption, growing at around 3 percent trend is higher than an estimated potential trend by 3-4 percent.
These imply that there is an imminent risk of inflation rising again, given that core CPI (6 percent) and PCE (4.7 percent) inflation are still high and real policy rate is still negative at -0.5 percent, far lower than FOMC’s projection of 1.6 percent.
Thus, learnings from past cycles suggest that the current feedback loop from the markets threatening a deep recession appears to be an attempt to force the Fed to back off from continued tightening.
Given the multi-decadal high inflation, Fed does not have the degree of freedom to pander to market expectations. The post-covid house price boom is having a second-order impact on rental inflation (7.1 percent YoY), contributing to high core inflation.
The predicament for the Fed is that while further tightening will necessitate deeper asset price deflation, it will also need to ensure that it simultaneously avoids the emergence of a systemic solvency problem.
The choice is narrow as the rate of transition into serious delinquency (90 days+) for mortgage loans has risen by 20-35bp since the bottom in Q3 2021 to an average of 0.5 percent, faster and broader than the phase before the subprime crisis 2006. US financial sector resilience will be tested if the housing boom were to follow a bust, contracting by 20-25 percent.
If the Fed concurs with the market expectations of premature easing, it will reinforce perfect predictability and hence conform to the rational expectation hypothesis which ordains the ineffectiveness of the central bank’s actions. This would seriously challenge the Fed’s credibility.
Accordingly, as objectives of price stability are only partially met it is likely that the Fed would not give in to the market pressures; sustaining an element of surprise would break perfect predictability thereby marshalling greater effectiveness.
Therefore, in the most probable scenario, the Fed would run through its guidance on rates with greater emphasis on quantitative tightening (QT). Hence, a potential reinforcement of restrictive stance by the Fed will be a pushback for the financial markets that is contriving a pre-mature easing later in 2023. The ramifications of such an event could lead to rise in market volatility and blunting of the extant risk-on sentiment.
Sensitivity of the Indian equities to surprises on Fed’s trajectory is high, specially in the context of significant overvaluation. India's MCap as a percentage of GDP at 107 percent is converging with the declining valuation in the US at 150 percent, and the trailing price-earnings ratio for NIFTY/Sensex at 23x is 55 percent higher than the global average of 15x and is rivaled by Japan and US which are at a premium of 26 percent and 35 percent respectively. In addition, the cuts in consensus earnings projections have been severe for non-finance companies and the prospective headwinds portend further downgrades. Overall, the combination of overvaluations, earnings fragility, and potential reaffirmation of the Fed’s tightening presage volatile market conditions.
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