Governors in the trap: the question that will determine the direction of the market in 2022

The key economic question in early 2022: Can the Fed not raise interest rates during high and sustained inflation?

The employment report released over the weekend will only hasten the expected increase, as the markets are signaling.

And what is expected in Israel?

Guy Beit Or, Chief Economist of Psagot Investment House

09/01/2022

Sunday, 09 January 2022, 11:24 Updated: 11:52

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The new year has opened with a storm and there are many developments in a variety of areas whether at the geopolitical level (Russia-Ukraine and Kazakhstan), whether at the economic level or in the markets and of course all of these are closely related to each other.

Still, in terms of markets today there is almost only one major game, or rather: one question whose answer will determine the direction of the coming year - and is: Can the Fed raise interest rates and reduce the balance sheet even in a situation where the markets are really unhappy? And in a slightly different wording, can the Fed not raise interest rates during particularly high and non-temporary inflation?

So what actually happened here last week? From the Fed protocol, we learned that Fed members are in a "hawkish" mood, especially when the 2022 menu includes not only raising interest rates, but also reducing the Fed balance sheet.

It is important to emphasize that in the previous round, when the Fed completed the acquisition plan, it waited almost 3 years in which it maintained a stable balance sheet before starting to shrink, but the reality in 2022 is completely different and the Fed's sense of urgency to complete monetary expansion and move to a more restrictive policy has never been Greater in light of inflation which, as is already known and clear to all of us, is not temporary and is probably much more stubborn.

Over the weekend, we got another justification for that same sense of pressure from the Fed to act soon when the December employment report gave us another very clear signal that the U.S. labor market is in full employment and that the wage pressures in it are just continuing to rise. On the one hand, the increase in jobs surprised down dramatically with an increase of 199,000 (expected to be 450,000), but on the other hand wages completed a jump of 4.7% in 2021, significantly above the expectation of 4.2%.

This combination of a "hawkish" Fed that is very troubled by inflation, coupled with this employment report that only heightened fears that the re-feeding between inflation and wages is growing, has led to increased volatility in markets at the start of the year with a jump in bond yields along the curve. New in stock markets.

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Fed President (Federal Reserve, US Federal Reserve) Jerome Powell: It will not be long before he is forced to raise interest rates, even in an inflationary environment (Photo: GettyImages, Alex Wong)

Estimate: The Fed will raise interest rates in about two months

So where do you go from here?

In our opinion, the Fed is expected to start raising interest rates as early as March and will strive to implement them faster than the markets are pricing today. However, it is very difficult to give a figure about how many interest rate hikes there will be for the simple reason that we do not know what the Fed's endurance will be for weakness in the markets.

We are talking about this quite a bit in the current economic cycle, the central banks have entered a trap. On the one hand, raising interest rates aggressively, as is probably required today, could lead to significant weakness in the markets. On the other hand, a slow rise in interest rates will probably not do the job in terms of controlling inflation and a non-rise in interest rates may lead to a loss of confidence in the central bank while a jump in inflation expectations.

Therefore, we assume that the Fed will raise the interest rate as long as the market allows it and in our view, in the current situation the market will not allow the Fed to raise the interest rate as they plan but again, here comes the issue of inflation and direction in 2022. There will be a choice even if the markets do not like it.

The significance for the bond market is complex. An analysis of the yield curve shows that interest rates and inflation have a very significant effect in the short and medium parts, but as we move up the curve, their effect weakens and the effect of the economic situation and stock markets intensifies.

We estimate that bond yields in the short and medium parts of the curve are still likely to continue to climb but with regard to the long parts, there are plenty of question marks - will stock market investors buy the declines in markets or return to long-term bonds? At least in the short term, it is certainly possible that the rise in yields has not yet ended as after the protocol a new component comes into play and that is the possibility that the Fed will actually start selling bonds.

We estimate that two developments are expected to support long-term bond yields, although timing is always problematic. And it is also likely to raise it faster than what is currently embodied in the markets, but the cycle of interest rate hikes will end sooner than expected which will ultimately support the long bond yields.

Governor of the Bank of Israel, Prof. Amir Yaron: Has Israel escaped the global inflation wave, or has it, like the Omicron, only been delayed? (Photo: Reuters)

And meanwhile, in Israel ...

What does all this say about the domestic bond market?

In terms of inflation, the situation in Israel is still very different compared to what we see in the US and Europe when inflation and inflation expectations are still within the target range. Assuming that inflation in Israel does not

skyrocket

unexpectedly, the main effect on the domestic market will come from abroad and will mainly affect the long sections of the curve. In our opinion, the risks to inflation in Israel continue to be

tilted

upwards due to the ongoing disruptions in the world's production and supply chains, together with the warming real estate market and wage increases that we believe are expected to increase.

Interest rate hikes by the world central banks together with an inflation environment that will at least be in the target area is expected to lead to our assessment of a rate hike by the Bank of Israel during the second half of the year but meanwhile, the Israeli bond market only reflects interest rate hikes at the end of 2023.

Guy Beit Or, Chief Economist of Psagot Investment House (Photo: Moshik Brin)

The author, Guy Beit Or, is the chief economist of Psagot Investment House

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