As the Fed delivers another 75bps hike, risks of policy error grow

On September 21st, the FED implemented another 75bps hike in Interest Rates, marking the 3rd consecutive oversized hike this year. Much to the dismay of equity and bond investors, FED Chairman Jerome Powell, as well as other voting members of the FOMC, continued to maintain a tough stance on future rate hikes, suggesting at least one more 75bps hike is in the books for this year, followed by a 50bps in November or December. 
The Bond and Equity markets reacted as expected to these comments and sold off on the news of another 125bps being planned for the months ahead. The 10-Year Treasury Yield briefly breached 4% as of September 27th, up 50bps from its previous high on June 16th which coincided with the lows of the year on equity indexes. As of the writing of this article, the lows of the year have been broken on the Dow Jones and S&P Indexes, though Nasdaq seems to be holding just above its own lows. 

Bond indexes have also moved lower since the rate hike came into effect, with the TLT long term treasury index coming down 4.6% since the announcement, and the US Aggregate Bond ETF down 1.9%. High yield bonds and short-term treasuries fared better, with the HYG and SHY down 2.6% and 0.3% respectively over the same weeklong period. 

Calls for a policy mistake are growing louder

The number of economists, academics, and investment professionals calling for a pause in the rate hiking cycle is growing with each new FED meeting. Notable names such as Professor Jeremy Siegel of the Wharton School of Business have not shied away from challenging Jerome Powell and the FED’s take on Monetary Policy over the last 2 years. In a recent Interview, Professor Siegel expressed his discontent with the current path of the rate hikes and questioned the validity of the data being used to justify the hike, claiming the data is outdated and backward looking by its very nature.

On a similar note, Jeffrey Gundlach, the so called “Bond King” of Doubleline Capital has begun purchasing Treasuries and has gone on record to say that he believes fixed income is significantly undervalued compared to equities. Given that Bond yields and prices are negatively correlated, this implies a fall in interest rates and a reversal of the FED’s plan to continue hiking.

On the other side of the debate lies Mohamed El-Erian, a Cambridge Economist who is of the opinion that despite the economic pain we have seen, the FED will and should continue to raise rates, to regain its credibility. His stance on continued tightening stems from a psychological and behavioral area of economics concerned with the perception of the FED by the Market, but he is also of the opinion that a significant policy error has been made and that the FED is currently in catch-up mode. 

Global effects of U.S interest rates

A perhaps unintended result of this hiking cycle has been the incredible strength of the USD relative to most developed nation currencies, and especially against developing nation currencies. This poses a challenge for developing nations with dollar denominated debt, which if left unchecked could begin to resemble the Latin American Debt Crisis of the 1980s. The rapid increases in interest rates in the 80s brought on by FED Chair Paul Volcker created a perfect storm for Latin American countries which issued U.S denominated debt a decade earlier, and suddenly found themselves unable to make the required interest payments. Although the inflationary bonfire was surely put out in the United States, the resulting debt payments crippled most nations south of the border, leading to a “lost decade” of economic growth.

Although too soon to tell, there are now concerns that emerging market economies holding U.S Debt will soon face a similar predicament if the relative strength of the dollar is maintained for too long. A memo from the Federal Reserve Bank of St. Louis warns of exactly this, with countries such as Argentina, Colombia, and Saudi Arabia needing to keep a close watch on their debt service levels over the coming months, as they are most at risk based on the available data. 

Summary of mentioned ETF Performance (1 month, YTD):