Are interest rates really heading higher?

While most investors are pre-occupied with when interest rates are going to be adjusted higher, particularly in the wake of much stronger-than-expected US consumer price inflation (CPI) data and rising inflation expectations domestically, this is largely yesterday’s story. A far more important question is how likely is it that investors might witness first steps towards more support rather than a tightening of economic conditions sometime over the next twelve months?

First, if you look at the latest US CPI data (4.2% annualised) it is not indicative of broad-based inflationary pressures. As highlighted by the Macquarie US economist, price rises were highly concentrated in a narrow range of spending categories (e.g., hotels, travel, airlines, used cars), and if you ignore these outliers, the underlying core inflation was only 0.3% for the month. Most of the inflationary pressures has thus far related to base effect, erratic demand and supply bottlenecks.

The same applies to most other jurisdictions, with G5 headline CPI rising from 0.6% in Feb’21 to 1.3% in Mar’21 and 2.1% in April.

It appears Investors are now close to the peak of the recovery, with the fastest pace of demand rebound priced in conjunction with the greatest fiscal and monetary supports in living memory. Meanwhile, the fiscal pulse is likely to weaken into 2022-23. If we consider yesterday’s budget delivered by Grant Robertson, much of the announcement was around the redirection of funds from the ‘Covid fund.’ Whilst there were additional funds allocated to infrastructure spending, the budget has been defined as more of a ‘social’ budget as opposed to one that is likely to spur a large scale economic recovery.

Given that this government has shown no ability to execute around fiscal initiatives, my fear is it will yet again fall to monetary policies to carry the burden. Whilst there is little doubt that a lot of the economic conditions around employment and inflation are starting to be met, a path to higher interest rates remains challenging.

Therefore, investors are facing extreme cross currents. A significant and unstable inflationary spike, followed by an uncertainty as to policy changes and its ability to de-stabilise any recovery. This promises to cause a great deal of volatility across assets over the coming months, as financial markets debate the likelihood of a sustained path to higher interest rates.