Higher For Longer, Cash Is Your Treasure
Federal Reserve Chairman Powell, in the US Congress hearings on March 7-8, warned that if US economic data continue to show strength, it could prompt the Fed to increase interest rates at a faster pace, possibly exceeding the 4.9%-5.6% range set at the December FOMC meeting.
The probability for 50 basis points in March FOMC meeting raised to nearly 78%; US 2Y Treasury yield, which directly reflected rate hike expectations, broke 5%. The two factors show that Fed will accelerate rate hikes rather than pivot.
Source: CME FedWatch
However, what Fed officials say is less important than whether US employment data cools down.
As of January 2023, US job openings, while beginning to decline, still stands at 6.5%. Likewise, the US labor force participation rate, despite continuing to rise, has not returned to pre-pandemic levels. Therefore, until the two indicators return to mean, the US unemployment rate is unlikely to rebound significantly from 3.4%, its lowest level since the 1950s, which could force the Fed to pivot.
Source: Bloomberg
Historically, once the unemployment rate begins to rise, it tends to become a runaway train that can't stop. This was the basis for Democratic Senator Warren's criticism at the hearing that Powell's accelerated rate hikes would come at the cost of 5-6 million Americans losing their jobs. Below is the video of Warren questioning Powell.
According to the economic forecast data from the December FOMC meeting, the US unemployment rate is expected to reach 4.6% by the end of this year, meaning it will rise more than 1% in one year from its current level. Since World War II, there have been 12 instances when the US unemployment rate has risen by 1% in one year. Afterwards, the unemployment rate continued to soar and never stopped.
Source: Bloomberg
After the unemployment rate starts tosoar, the median rise from the low is as high as 3.6%, and the unemployment rate will rise to at least 6.1%.
We believe that the Fed, which takes action based on data, will continue to maintain a strong stance on rate hike expectations until the unemployment rate shows signs of soaring. After all, if excessive rate hikes lead to a recession, the Fed can replicate the successful experience of cutting rates in 2020. However, there is no experience to follow if rate hikes are insufficient to meet inflation targets.
In this case, the financing costs and operating efficiency of US companies will continue to be severely tested. Morgan Stanley's chief strategist, Mike Wilson, pointed out that
the expected earnings of the S&P 500 equal-weighted index compared to the US 10-year Treasury yield is at its lowest point in nearly a decade, indicating that the current relative value of US stocks to bonds is at a 10-year low.
Source: Morgan Stanley
The probability of a "soft landing" for the US economy is decreasing. In the first half of the year, the US stock market may remain in a state of "no landing" due to the remaining economic heat. However, in a high-interest-rate environment, if economic data related to the service sector starts to weaken, company earnings will go down faster, and the market will quickly revert to the recession trading. The probability of a "hard landing" for the US stock market will increase.
Source: Bloomberg
As shown in the above chart, the inversion between the current US 10-year Treasury yield and the 3-month Treasury yield is at its most extreme degree since 1981. Historically, when the Fed stops raising interest rates and the 10Y-3M Treasury yield spread begins to shrink, a stock market crash will emerge. We believe the market crash may occur in the second half of this year.
To sum up, the job market needs more time to cool down; the pace of interest rate hikes has not stopped; the stock market is still volatile and full of great uncertainty. Therefore, at present, it is prudent to allocate most of the funds to the US dollar money market (has good liquidity) to obtain risk-free returns, while allocate a small portion of the funds to bet on the rebound of strong stocks in the US stock market when there is a market crash.
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