- Macquarie analysts now see four rate hikes coming from the US Federal Reserve this year instead of three, and bond yields pushing higher.
- Continuing strong job creation in the US will force the Fed’s hand, the analysts believe.
- This will put pressure on stock valuations.
Macquarie Bank has lifted its forecast for the number of interest rate hikes coming from the US Federal Reserve this year, and warned of higher US bond yields and a “challenging environment” for stocks.
Analysts David Doyle, Neil Shankar and Ric Deverell now expect the Fed to hike interest rates as much as eight times over the next two years on the back of stronger labour market conditions.
“We update our profile for the Fed Funds rate, raising our forecast to 4 hikes in 2018 and 3-4 hikes in 2019,” the trio wrote earlier this week.
“A steady decline in the unemployment rate, solid real GDP growth, and a firming inflation backdrop should keep the FOMC hiking once per quarter for the next two years.
“Underpinning our view change is that the payrolls deceleration has softened considerably with the annual revisions that were released in January’s report.”
Macquarie now sees average payrolls growth of 150,000 per month this year, and 125,000 per month in 2019, something that will act push US unemployment down to levels not seen in over half a century.
“Our analysis suggests that underlying labour force growth remains 70,000 per month, meaning that downward pressure on the unemployment rate should continue for longer,” Macquarie says.
“The unemployment rate should fall to 3.6% at end-17 and 3.3% at end-18.”
And with concerns about disinflation having ebbed substantially, Macquarie says this tightness in the US labour market — something that points to a further acceleration in wage pressures — will see the Fed not only continue to lift interest rates, but increase the pace of hikes considerably.
“As the labour market tightens further and the unemployment rate continues its steady decline we believe that wage growth can move upwards to around 3.6%, a level that we believe will prove to be an equilibrium in this cycle,” the bank says.
“This dynamic should mean the FOMC is likely to continue to hike. And with concerns about low inflation diminishing, the threshold of financial market volatility required to skip a quarter is far higher than it was in recent years.”
Given the expectation that the Fed tightening cycle will accelerate this year and next, Macquarie says US 10-year bond yields will push significantly higher over the next two years.
“Our end-cycle forecast rises to 3.75%,” it say, noting this is a substantial revision on the 2.75% level it previously forecast.
“We anticipate that for the next three to six months, the 10-year yield will stabilise around 3.0% before it begins to move gradually higher through [the end of] 2019.”
Macquarie says the evolution in US wage pressures will be key to determining whether or not this happens.
“Over the last decade, the 10-year yield has largely tracked average hourly earnings growth. With unemployment falling further, average hourly earnings should pick up, adding to the upward pressure from rate hikes on the 10-year yield,” it says.
The reduction in the Fed’s balance sheet, along with an end to the ECB’s asset purchase program late this year, are other factors the bank says could place upward pressure on treasury yields.
So, in Maquarie’s opinion, wage and inflationary pressures will increase in the years ahead, as will the pace of rate hikes and lift in bond yields.
As we all witnessed first-hand last week, that’s a scenario that doesn’t usually mix well with stock valuations.
Macquarie says that’s unlikely to change, noting that “a rising 10-year is a valuation headwind for equities”.
“The shift in our outlook suggests a more volatile and challenging environment for equities,” it says, adding that “the period of multiple expansion is likely now in the rear-view mirror”.
In its opinion, things have the potential to get gnarly for stocks once 10-year yields bust convincingly above 3%, something the bank expects to occur by the end of this year.
“Our analysis of the equity risk premium suggests that should the 10-year move beyond the 3.0 to 3.2% range, it will create a valuation headwind,” it says.
“Our end-19 forecast of 3.75% implies a further 10% earnings multiple decline.”
While that would almost certainly act to lift volatility, Macquarie adds that stocks, in general, “may yet rise as earnings growth should exceed this”.
“In addition to favouring Financials, we believe the macro backdrop should be supportive of consumer discretionary,” it says.
While much of Macquarie’s focus is on the United States, as most investors are already acutely aware of, what happens in the US markets doesn’t usually just stay in US markets.
Interesting times ahead.