Signal or Noise: Big hikes, recession calls, and a 4% interest rate?

Livewire Exclusive

Livewire Markets

Welcome to the very first edition of Signal or Noise - Livewire's brand new series dedicated to data and economics. 

Our mission for this series is simple - to make the big picture more interesting and relevant to you. 

Economics can be convoluted, complex, and let's face it, confusing. So in this series, we'll be clearing up the grey areas with the help of some top-notch guests. They'll be tasked with analysing three topical stories or data points - and deciding whether they believe investors should take these as a signal or noise.

Much like its companion and inspiration (Buy Hold Sell), this series will be available in video, audio, and of course, wire form. You'll be able to catch Signal or Noise once a month, so follow the series below so you never miss an update.

Why now?

We couldn't have timed the release of this series any better if we tried. For the first time in more than a decade, central banks across the globe are raising interest rates. They are also doing it at a breakneck pace - putting everything from asset valuations to your mortgage into a tailspin. 

For the first time since the Arab Spring, global inflation is also a major watching point. Much like then, there is no clear sign of when signs will let up. Unlike then, consumers are now more nervous than at any time in recent years.

In the markets, equities are selling off after a 12-year bull run while bonds are coming back into vogue after a period of sustained underperformance. Most crucially, central banks have been caught behind the curve on inflation. Now, they have to hike enough to get rid of it without blowing up the economy.

If all this sounds familiar, it should be. It can also sound really noisy and confusing. That's what this series is going to change.

Meet the team

Hans Lee is our moderator and Livewire's economics guru. He also writes Charts and Caffeine - the website's daily pre-market wrap combining the best of many asset classes.

Diana Mousina is AMP Capital's senior economist and our regular panellist. With two degrees to her name, Diana cut her teeth as an economist at the CBA. She moved to join AMP Capital in 2016, working alongside Dr Shane Oliver. Diana comes to this series with the perfect mix of economic analysis, easy explanation, and multi-asset interpretation. 

No matter what you invest in, Diana's probably got an opinion about how the economics will affect your money.

Diana and Hans will be joined each month by a rotating team of Livewire's best guests in the fields of macro, fixed income, and asset allocation. 

For our first episode, they are joined by Chris Rands of Yarra Australian Bond Fund and Shawn Hickman of Market Matters.

What to expect

Every month, the team will analyse the biggest topics affecting your money in the world of economics and macro. In this episode, they are tackling the following subjects:

  • The Federal Reserve's 75 basis point hike (and the likelihood of more)
  • Can the RBA hike rates to 4% without causing a recession?
  • A reliable precursor to a recession strikes twice

To get a taste of what we'll be covering, you can click the video or read our edited transcript.

Note: This episode was recorded on Wednesday, June 22nd, 2022.

EDITED TRANSCRIPT

Hans Lee: Hello, I'm Hans Lee and welcome to the very first edition of Signal or Noise, brought to you by Livewire Markets. This is our brand new video series dedicated to all things data and economics, and how we're going to make that more relevant and more interesting for your investments.

I'll tell you what, what a time to be launching a show like this. And as a result of that, we have three great experts on the panel. We've got Chris Rands of the Yarra Australian Bond Fund. Good to have you, Chris. Diana Mousina of AMP Capital and Shawn Hickman of Market Matters. Thank you all for coming.

We're going to delve into a lot of topics on this show, but I thought we might begin with the elephant in the room. And that is the Federal Reserve. Recently, of course, chair, Jerome Powell, decided he would hike rates by 75 basis points. The first time that's happened in nearly 30 years. And then he added that 50 basis points or 75 might be in consideration at the next meeting, suggesting that the era of free money, the era of easy hikes are coming to an end.

Chris, I might start with you first and we'll go around the grounds. What do you reckon his quote specifically of saying 50 or 75 down the line? Do you treat that as signal or do you treat that as noise?

Chris Rands: At the moment, I think it's a huge signal of what's to come. Not only that they did do the first 75, but also, if you look at the meeting statement from the Federal Reserve, the way that their unanimous decision has shifted. If you look three months ago, there was actually quite a lot of dispersion in the Fed dot plot of where they thought the cash rate was going to be. There were some at 350 [basis points], and there were some at 150 [basis points]. 

If you roll forward to now, basically everybody is sitting at three to three and a half percent. The only way to get to three and a half percent by the end of the year is to start jagging rates up quickly.

Hans Lee: And we should explain to the viewers out there. I mean the dot plot is, it's almost like gospel, isn't it, in some sense? Because that's how market participants really apply, "Oh, this is worth things that the big wigs, the officials see. This is where we see things going."

Chris Rands: Yeah. The simplest way to describe the dot plot is it's a representation of what each Fed member believes the cash rate will be in 12 months, 24 months, and 36 months. It's not where it will end up being, but it's their best guess of where they think it will be.

Hans Lee: What do you reckon as well, Diana? Do you treat that as a signal or do you just treat that as noise? Especially given what central bankers have projected in the past and, of course, what's ended up being the case.

Diana Mousina: I'm taking it as a signal. I think central bank reaction functions have shifted not just in the US, but also in Australia. Six months ago, the talk about transient inflation was still very apparent in central bank communications.

And now, there's been more inflation coming up in different pockets, like in energy, the flow-through from commodity prices as well. Central banks have had to change their view on inflation, and upgrade their projections. 

And then ultimately, that means that they have to change their assumptions for interest rates. It's a signal that interest rates will be headed much higher from here.

Hans Lee: Shawn, what do you make of things?

Shawn Hickman: I think it's definitely a signal. You can't ignore it. Interestingly, I think a bit like what Chris is saying. The stock market is already saying recession next year. We saw that from oil last week. They're already getting very, very scared, very, very quickly. The stock market's dropped 25% already, top to bottom. Over the last 12 recession-induced share market corrections, the average pullback is around 30%.

We're almost there. There have been three outliers between 40 and 50%. The share market is scared. People are scared. Because of the amount of free money out there, we'll probably go more than 30%. But people are scared. I think we'll be at three and a half percent by Christmas, 4% by next year. Then I think they've gone too hard and we'll see rate cuts.

Hans Lee: Well, rate cuts is where we're actually going to start the next conversation because we're going to move now to here at home. The RBA again, like all sorts of other central banks, is under the same kinds of pressure. Inflation, the consumer once being resilient, now maybe that's a little under the cloud.

And there are rates traders that have been pricing in three and a half, 3.75, even a 4% terminal rate by the end of next year and then maybe a recession. And then, we haven't even got to the subject of rate cuts. 

To you, Diana, on this one I think. A 4% terminal rate or endpoint for this cycle in Australia. Do you believe the market? Is it a signal or a noise?

Diana Mousina: Noise. I haven't believed the market for some months and the market has been right in terms of aggressive RBA rate hikes in the short term, but a 4% cash rate in Australia would tip us well into recession. Now, maybe the RBA wants to generate a recession here to get inflation down. 

That's a possibility I think that we need to keep in mind - we need to take into account that maybe the market is assuming that the RBA will tip us into a recession.

I just don't think that the RBA will need to see Australia in recession to get inflation down. We're already seeing signs that inflation is starting to slow in some of the global supply chain indicators. The RBA rate hikes are already doing what they need to do to slow consumer demand. And we've only had 75 basis points of rate hikes so far.

Home prices are declining. Some of the bank's weekly credit card data is softening as well. I don't think that the RBA will need to go as hard. I think we'll see the peak between two and a half to 3% in the cash rate.

Hans Lee: Shawn, from where you are. I mean, because obviously, you're not just dealing with just the economics, but of course, you also deal with equity markets and those kinds of asset classes. How does that kind of a future impact the way that you guys are seeing valuations for equities?

Shawn Hickman: It's an exciting opportunity, but also scary. I think we'll see two and a half percent by Christmas. I think we might see 3% by next year. Then I think we might see some rate cuts into the middle of next year. Time will tell. It's a bit of guesswork out there as we know already.

If that happens, we will see some quite dramatic changes in the cycle to the stocks you want to own. We've had already the hammering of the tech stocks, the hammering of the high-value stocks. That's not going to change in the short term. I think we're seeing improvement in the quality of stocks. People just want to buy quality at the moment, whether it's in the bond market or whether it's in equities, they want quality. 

They want to feel comfortable. They want to sleep at night. They want to see what comes next.

I think the RBA's a bit scared. I think they've gone late. We're still behind most of the central banks, but we've got some interesting balances going on here. We've still got an unemployment rate at a 48-year low. We've got $270 billion worth of cash sitting in people's pockets from the handouts during COVID.

I think we're going to get, unfortunately, a fair bit of polarisation of wealth and that could cause some headaches for the RBA. They're going to get some inflation in places and they're also going to get a lot of pain in places. And quite how they juggle that, it's a bit like a gymnast walking along a beam. It's a very hard game to play. I wouldn't want to be in their shoes.

Hans Lee: So do you treat that as noise as well?

Shawn Hickman: I'm going to lean more towards a signal at the moment, but I think it'll be noise in six months' time.

Hans Lee: Chris, to you. I mean, being in the rates market, you see that every day. The ASX OIS curve is probably something that you look at on some level of frequency. What do you make of all this?

Chris Rands: Unfortunately, I'll say that the market pricing to me looks like an absolute load of noise. When I look at what's going on, they're pricing the Australian market the exact same way that the US Federal Reserve is.

And as we said before, the Federal Reserve is talking three and a half, potentially higher cash rate. Whereas if you listen to Philip Lowe, if you look in the RBA meetings, they're saying somewhere between two, 2.5 by the end of this year is what they're comfortable with.

And for the market to be pricing four (percent), that's probably one of the biggest dislocations that I've seen between what the economists, what we think is appropriate for the economy, and then what's being priced for quite some time.

Hans Lee: On this theme, I hear everybody saying, "Well, okay. Well, two and a half percent terminal rate, 3% terminal, that's the end of this cycle." Is it still too early to be talking about rate-cutting? I mean, we've already seen CBA economists say they could see a rate cut by the end of next year. Deutsche Bank I was reading before shooting this, was saying the same thing. Is it too early to be talking about rate cuts?

Diana Mousina: No, we've got rate cuts priced into our profile second half of next year. And we have already had that for some months. 

We did have it in 2024 and we've pushed it back early now because the RBA we think will be more aggressive in the short term. But ultimately, we think inflation will slow in six to 12 months' time because of some of the supply side issues, which will abate as consumer demand slows. 

Hopefully, some of the commodity price impacts as well will also slow. As Phil Lowe said the other day, petrol's unlikely to continue making the same contribution to headline inflation. When you get that slowing in inflation, the RBA will have room to cut interest rates.

Hans Lee: Shawn, do you feel the same way?

Shawn Hickman: I think we will definitely, to a certain degree. I think we're going to see things like food prices come back a bit. The floods problems are two to three months out, they're going to come back a bit. We're going to see, as you said before, petrol. I don't think it's going to go much higher. But it's not going to go away as well. Old energy is still going to remain expensive. People have got less money in their pockets. They've still got problems. It's going to slow people down.

Hans Lee: Chris, what are your thoughts?

Chris Rands: I don't think it's too early because if you look at the reaction functions of central banks, historically, they go too quickly too fast. And then when they start to see the economy slow, they've quickly got to turn the other way. And so that's why those recession indicators that you see coming out of the US, consumer confidence, credit spreads rising, curve flattening, those types of things say, you're getting to a level where you need to start being careful.

Hans Lee: And this is the thing, and this is the thing we want to stress to all of you. It's very much about expectations. It starts with the expectations. Then it's about how that's reflected in the economy, and then from there on in.

Shawn Hickman: Consumer confidence, just to pick up on that note, it's never been so low at the start of a rate hike cycle. That puts a lot of pressure on how far you go before people really start pushing back.

Hans Lee: We were talking about rate cuts just then. Why don't we just proceed to the last topic of this particular episode? And that is the inevitability of a recession. Something I suppose the professionals really love looking at is this idea of a yield curve inversion. The idea is that there are times when the income that you could get on a shorter maturity, may end up outweighing something that if you held it for far longer.

Well, that's called a yield curve inversion. And traditionally, that has preceded, fairly reliably, some sort of recession. Well, in this case, it's happened twice in three months. It happened in April and it's just happened in June. Basically, the question I'm going to be posing to you, the panel, Shawn, we'll go to you first on this one, does lightning strike twice? Or is this time different?

Shawn Hickman: I wrote down at the start of this chat, that noise for this one, just because this tends to be a six to 18-month lag in an indicator. And we're already there. We're already talking about a recession next year, the end of next year. That's why I'm calling it noise because it's old news. It's old news more than noise.

Do I think we'll get a recession next year? I think there's a good chance. 

Depends on how well these guys manage the economy. It's a really, really tough job. Coming back to that question, the share market is probably factoring in a 60, 65% chance for a recession. I don't think the likes of crude oil I get, but there are still a lot of situations out there which say we could get there. You can't ignore it. You definitely can't ignore it.

Hans Lee: Welcome to a market where three months is officially too long to think about things. Chris, what do you reckon?

Chris Rands: I think this is a pretty big signal. Obviously, I'm in the bond market, so curve inversions are what you live and breathe. But when I explain the curve and the explanation of what's going on, the way that I generally think about it is, if I gave you the opportunity that you had to hold on to an investment for five years and you could have cash or a five-year bond.

The fact that the five-year bond is below those short-dated bonds tells you that the market is expecting that cash profile to drop. 

And that inversion then says cash usually only drops when you're in a recession or growth is slowing. That's why it's such a strong signal. You're pushing the cash rate too fast. And the long end is telling you're about to break something.

I don't think of it generally as a binary event of once you're below zero, it's a recession or not. Generally when you look at the curve, if it's nice and steep, you've got a better chance of better outcomes. If it's flattening down, it's telling you something about the economy. And when it really starts to invert, that's when you're very close to the end.

Hans Lee: Diana, you look at all sorts of asset classes in addition to your roles and economists. What do you make of that?

Diana Mousina: I'm taking it as a signal for now. It might not necessarily be a signal of a recession, but it could be a signal of a potential recession in 12 to 18 months' time. When I look at some of the indicators for yield curves, I see it as more of a leading indicator on a 12 to 18-month time basis. Rather than at a current picture, like you were talking about. Although we could be in a recession right now in the US. Might not be a technical one if the NBR doesn't classify it like that, but we could still be in one.

Or it could be a sign that we're headed for a larger market downturn in six months' time, which is another possibility. Or that the Fed has made a mistake, which we're pretty much all in agreeance that they will have to cut interest rates in the second half of next year.

But it's a signal that we could be headed into some of this tough territory. The next few months might be tough for markets, which is our base view. But at the same time, the other indicator of the yield curve, the 10-year, and the Fed funds rate is still very firmly positive and it hasn't inverted. It is a signal.

Hans Lee: Thank you for watching out there. These three, I'm very happy to say, will be back for the second part of this episode, where we're going to ask them to bring a chart that is interesting to them. We hope you'll stick around for that. And if you do like what you've just seen, make sure to subscribe to the website and the YouTube channel. We'll see you next time.

Enjoying Signal or Noise?

Give this wire a like if you've enjoyed the discussion and hit follow to be notified when new episodes are released.

If you're not an existing Livewire subscriber, you can sign up to get free access to investment ideas and strategies from Australia's leading investors.

........
Livewire gives readers access to information and educational content provided by financial services professionals and companies (“Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.

1 fund mentioned

3 contributors mentioned

Livewire Exclusive brings you exclusive content from a wide range of leading fund managers and investment professionals.

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.