Interest rates, inflation and a seesaw battle between the Fed and the Treasury

In the final quarter of 2023, global financial markets embarked on a spirited risk-on rally. This surge in optimism was largely fuelled by investor speculation that central banks were finally poised to pivot, starting in 2024, leading to excitement in the markets. But are markets celebrating too early?

In October, unemployment numbers showed signs of moderation relative to expectations, leading investors to think that it was an opportune time for central banks to adjust their tone regarding monetary policy. From the end of October to November and December, there was a significant rally across various markets. The Federal Open Market Committee (FOMC) meeting held in December also played a crucial role. The FOMC members’ interest rate projections, compared to their projections from the September meeting, showed that they expect rates to be much lower in 2024, and specifically, 0.75% lower by the end of the year. The significant shift in rate projections for 2024 signals a more accommodative monetary policy stance, and Powell’s dovish remarks further solidified this market narrative.

However, while the numbers may appear dovish, the reality is actually more nuanced. The Fed’s primary concern currently is inflation, and core inflation, which excludes volatile elements like energy and food prices, in the United States (US), is still stubbornly high at 3.9%, which is well above the Fed’s target. And there is a specific culprit for that: the US services ex-shelter component. This slice of the economy shows remarkable stickiness and is a cause for concern because it reflects the dynamics of the labour market. As businesses reopen and hiring accelerates, wage pressures intensify. If core inflation remains elevated, it limits central banks’ ability to manoeuvre, and aggressive interest rate cuts can become challenging to implement.

Additionally, when the central bank made an unprecedented liquidity infusion to protect the economy during the pandemic, the unintended consequence was a flood of liquidity. Investors, flush with cash, sought higher returns causing prices for assets like stocks, property and cryptocurrencies to surge as they rode the liquidity wave. As more money flowed, so did inflationary pressures. After recognising these risks, the Fed began tapering off asset purchases and later reduced bond holdings to drain excess liquidity and curb inflation. However, while the Fed embarks on this quantitative tightening, the US Treasury is playing a different tune and ramping up the issuance of Treasury bills, notes and bonds to fund pandemic relief and infrastructure spending - injecting fresh liquidity into the economy. What is the net effect of this? After examining the Fed’s balance sheet, the Treasury’s general account and the reverse repo market operations, overall US liquidity is running sideways and seemingly making it difficult to keep inflation under control for an extended period. With sticky core inflation, wage pressures and liquidity injections from Treasury, perhaps the rhetoric of “higher for longer” will live on.  

The global economy, particularly the US, plays a pivotal role in shaping South Africa’s monetary policy. The South African Reserve Bank (SARB) has been steadfast in its commitment to maintain price stability and, at a time of global uncertainty and domestic challenges, the Monetary Policy Committee (MPC) faces the delicate task of managing inflation while supporting economic growth. Initially, market expectations pointed toward rate cuts in the second quarter of 2024. However, projections have shifted further out into 2024. This postponement reflects the persistent inflationary pressures that continue to grip the economy. Overall, the risks to local inflation are to the upside, with South Africa’s consumer inflation printed at 5.1% year-on-year in December, remaining on the higher side of the SARB’s target range. While it is probable that local interest rates have peaked, envisioning a deep interest rate cutting cycle occurring locally is challenging. Eventually, a cutting cycle may occur, but it is likely to lag the developed world.

As central banks around the world continue to grapple with these complex dynamics, it is essential to consider investment options that provide reliable and predictable returns. Fixed income is an incredibly attractive asset class in the current interest rate environment, and in the face of current global challenges, with inflation a formidable adversary, the Nedgroup Investments Flexible Income Fund stands as a beacon of consistency and stability for our clients. The fund follows a diversified approach, and rather than trying to predict and invest for a single outcome, the fund strategically invests across a diverse spectrum of fixed income asset classes. This approach ensures predictable returns while maintaining a low-risk profile. The fund places a strong emphasis on risk management and actively seeks to protect against downside risks. Risk management and downside protection are prioritised over short-term gains. By doing so, it aims to shield portfolios from sudden, and large capital losses. As we navigate this uncertain landscape, our commitment remains steadfast: to safeguard our clients’ investment portfolios while fostering sustainable growth. The Nedgroup Investments Flexible Income Fund is not merely an investment vehicle, it is a core holding to secure financial well-being during times of global turbulence and market volatility.