As the Fed's interest rate hike in March approaches, the market is ready for the Fed's rapid interest rate hike in 2022. However, after the outbreak of the Russian Ukrainian war, there was a strange phenomenon, that is, the market expected the Federal Reserve to cut interest rates slightly in this round of interest rate hike cycle. At present, the market expects the Federal Reserve to raise interest rates eight times by the end of 2023, and then raise interest rates after a small interest rate cut, rather than the relatively slow and continuous interest rate increase expected before the outbreak of the war.
Why are these expectations? What is the reason for the fed to interrupt a rapid interest rate hike cycle with a short interest rate cut? We believe that the Russian Ukrainian war made the market realize that the Fed is likely to curb inflation at the cost of a small economic recession in the future.
In the short term, the risk of US inflation after the Russian Ukrainian war is more imminent than the economic slowdown. Since 2022, the surge of inflation in the United States has exceeded that in the late 1960s, and the outbreak of the Russian Ukrainian war is likely to make it comparable to the Great Inflation in the 1970s; At the same time, since the nominal interest rate has remained low after the epidemic, the soaring inflation has led to the further decline of the Fed's actual policy interest rate in the negative range. As a result, the degree of monetary policy easing is much higher than that in the 1960s-1970s. It can be seen that if the Fed does not raise interest rates quickly, it will only further contribute to inflation, especially the economy has superimposed supply shocks.
In the medium term, the risk of US economic recession in 2023 is real. Although it is not a good way to curb inflation by rapidly raising interest rates to combat demand, the Fed has no choice in 2022. The direct result is that the yield curve of US bonds is likely to be upside down in 2023. Judging from the recent performance of the US bond market, the 10-year-2-year interest rate spread has been less than 30bp. Although there may be an upside down during the year, we are not worried about it, because it also had an upside down in June 1998, but did not foresee an economic recession. For the more noteworthy 10-year-3-month curve, its upside down since 1970 has foreseen the economic recession. Because it is still as high as 160bp, the Federal Reserve needs to raise interest rates by at least 150bp before the upside down can occur, which also means that after raising interest rates six times, the risk of economic recession in the United States will increase significantly.
Will the Fed raise interest rates after the upside down of the US bond yield curve? Yes, since the supply side problem will not be significantly alleviated in 2022, even if the interest rate hike suppresses demand, our updated inflation model predicts that the core inflation of the United States will still exceed 4% by the end of 2022, and inflation at this level will still depress the confidence of American consumers, which is unacceptable to the Federal Reserve. Therefore, the Fed will ignore the upside down of the yield curve and continue to raise interest rates until the economy is on the verge of recession. From the current point of view, the market seems to believe that the Fed can avoid recession by raising interest rates slightly after 2023, but if the inflation risk remains, the Fed will still raise interest rates again.
What enlightenment does the deduction of the above scenario have on asset allocation? We believe that the main certainty is gold. Historically, gold has performed well when the Fed continued to raise interest rates to keep up with inflation until the economy went into recession. For example, in the 1970s, the Federal Reserve was forced to raise interest rates in response to inflation twice until the economy fell into recession. The increase of gold was as high as 113% and 244% respectively. When the Federal Reserve raised interest rates and contracted the table at the same time around 2017, gold also rose by 15%. Therefore, although we are clearly optimistic about gold this year, in the upcoming round of fed interest rate hike, we expect the price of gold to continue to rise to $2300 / ounce in the next 12 months.
Risk tip: the spread of the epidemic exceeded expectations, and the effect of policy hedging against the economic downturn was less than expected
