Central Bank Interest Rates

Here is a key macro indicator almost nobody is talking about. Debt service ratios (DSR) measure the amount of disposable income which is used by non-financial corporations and households to service their outstanding debt payments. In other words: how much of your salary is spent to cover your credit card and mortgage debt, or how much of corporate earnings are used to pay interest (and eventually principal) on outstanding loans and bonds. This is a crucial metric because it efficiently visualizes the pass-through of monetary policy tightening on the private sector. After all, the process by which raising interest rates is supposed to slow the economy works as follows: 1) Higher interest rates increase the borrowing cost for the private sector; 2) As a result, households and corporates slow down spending, hiring and consumption; 3) Ultimately, that's how the economy does what Central Bankers wanted when they started hiking: it slows down. Increasing debt service ratios (DSR) are a key indicator that the private sector is getting hurt by higher interest rates, and therefore that the economy might soon be slowing down. So: where are we today with debt service ratios? I looked at some of the major economies in the world and found that: - Australia, Canada, China, Korea, Norway and Sweden are under pressure Their DSRs are high in absolute terms and higher than their 20-year average, and the trend is also negative as they keep increasing over time. Unsurprisingly, these economies are already struggling a bit. - Europe and the UK are having a very slow pass-through so far Although that might change soon given the refinancing cliffs in Europe and the nature of the mortgage market in the UK - In the US, the big Fed hiking cycle has so far led only to a modest increase in the debt service ratio The US DSR increased to 15% (the US historical norm) with a very mild ongoing negative trend: households and corporates were smart to lock in low rates for long, and so the pass-through of Fed hikes has been quite slow so far. Keep monitoring the Debt Service Ratios: a key macro variable almost nobody is talking about, yet one which could give important indications about where different economies are going. Which economies do you think are the most exposed here? P.S. Enjoyed this macro analysis? Follow me (Alfonso Peccatiello) so you don't miss any post and stay updated on the launch of my Macro Hedge Fund! P.P.S. FREE TRIAL to my Institutional Macro Research? Join the biggest institutional investors in the world reading it every day - send me a DM and I'll set you up!

…It has begun. Over the last year, I have made the strongest possible case for the Fed to be proactive. Rates should have been cut this week – indeed, the rates should have been cut in January. We have seen this movie before. The Fed was very late to take inflation seriously in 2021. They brushed it off as “transitory”. However, it seemed obvious that inflation was surging. Real-time shelter inflation was increasing at a double-digit rate. Shelter has the largest weight in the CPI. Shelter operates with a lag. Hence, it was easy to forecast the surge. The Fed was forced to react after the damage was done. The same mistake has been repeated – despite many warnings. The recent CPI print was 3% year-over-year (YOY). Nearly two thirds of this print was driven by one component – shelter. Shelter inflation is reported at 5.2% YOY. This number is far from reality. For example, Apartmentlist.com rents are running -0.8% YOY - a full 6% below the official CPI number. Suppose we believe the real-time shelter inflation is 2%, not 5.2%. This means the real-time CPI would be 1.8%. If you believe shelter is 3%, then real-time CPI would be 2.2%. These numbers are well within the Fed’s target. The Fed prides itself on making data-driven decisions. However, it is unwise to make decisions based on stale data. The shelter inflation happened in the past. Keeping rates high will not impact what happened last year. It is always best to look at forward-looking indicators for policy decisions. ·      My yield curve indicator has been inverted for 20 months. It is 8 of 8 with no false signals since the 1960s. The maximum historic lead time has been 23 months (before the great recession). Ignore it at your own risk. ·      The Sahm Rule has been triggered. This indicator is not necessarily predictive because employment moves with the business cycle – but it is useful in telling us whether we are in a recession or not. We know that hiring has slowed and unemployment has risen – though the absolute rate is still relatively low. ·      Retail sales are highly correlated with personal consumption expenditures. Retail Sales are flat. Many do not realize that Retail Sales are not inflation adjusted. Taking inflation into account recent sales growth as well as YOY sales are negative. ·      There is considerable evidence that COVID-era savings have been drawn down. A recent release from Philadelphia Fed carried the headline: “Share of Delinquent Credit Card Balances Reaches Series High”. (The same report shows an alarming plunge in mortgage originations.) People are paying 20%+ interest on a card because their savings have run out. Indeed, if people are cutting back on fast-food expenditures, you know this is serious.  Drawing down the savings has fueled consumption expenditures over the past two years. That source of growth has ended. Now the Fed will have to play catch-up and cut by at least 50bp in September. Any recession is a self-inflicted wound. 

A historic moment in the World Markets - The Bank of Japan ends 8 years of negative interest rates, making a historic shift with the first rate hike in 17 years! This has officially ended the world’s only negative rate regime A quick explainer of why this happened - Some backdrop- - If you deposit money in an Indian Bank today u get 6% interest yearly, so if you Deposit Rs 100, you get Rs 6 as interest - But not in Japan! They had negative interest rates! - They had -0.1% rate, so if u kept 100 Yen, after 1 year you would get back 99.90 Yen - You are paying money to the bank basically to park money! Feels weird right? Let me explain 3 things – #1 - Why the negative interest rates? - Interest rates are central Bank tools to control inflation. It is called Monetary policy - Japan was stuck in a deflationary (falling prices of goods and services) phase for many decades. - They also entered a recession from 1995-1998 - Elongated deflation - falling prices in their goods and services, fewer earnings for companies, fewer wages, less employment, and a big impact on the economy (20 years of no growth + aging population) - Post many monetary policy measures, they entered -ve interest rates in 2016 – so that Banks can lend more and force people to spend more over saving so that the economy can be re-ignited! #2 - Why the end of -ve rates? - Jan prices rose 2%, 3rd month of rise (inflation = prices rising) – so they have increased rates from -0.1% to 0 to 0.1% - Wage increases – Rengo (Japan’s largest Labor Union) said the average wage increased by 5.28% (the largest since 1991) #3 - Impact/Conclusion - - BoJ will not go on an aggressive rate hike cycle as per their comments - They can’t keep rates down when worldwide rates are up - Financial markets had repositioned over the past week already (news/speculation) Hope the above post simplified everything for you Follow me Aditya Kondawar for more such simplifications

The Federal Open Market Committee (FOMC) has strongly signaled that they won’t cut the Federal Funds Rate until September at the earliest, and likely only once in 2025 (unless the employment data shows significant deterioration). One reason for this is the FOMC is quite worried about sharp increases in inflation expectations exhibited by both consumers and businesses. Two charts below show these dynamics. Thoughts: •The top chart shows the median point prediction for the year-over-year inflation rate one year from now from the New York Fed’s Survey of Consumer Expectations (https://lnkd.in/g4Tsdtej). As recently as November, inflation expectations were back to 3%, which was the stable, pre-COVID level. Since then, inflation expectations have surged to 4.79% as of April. We know the culprit: tariffs. •The bottom chart shows the expected change in prices paid over the next 12 months for inputs from the Richmond Fed’s manufacturing survey (https://lnkd.in/gvHt3VQa), with data through May. While May’s reading came down to 6.75% from 8.38% in April (likely due to the China tariff pause), we can again see a sharp increase in inflation expectations that can only be due to one thing: tariffs. •Why do inflation expectations matter? In the FOMC’s mind, inflation expectations can turn into a self-fulfilling prophecy. For example, if firms expect to pay more for inputs, it makes it easier for suppliers to raise prices. While I think inflation expectations are often incorrectly predicted (e.g., consumers in 2022 were expecting 8% inflation over the next year, something that certainly didn’t come to pass), the FOMC gives these data weight in their decisions on the Federal Funds rate. Implication: the impact that tariffs have had on inflation expectations this time around, relative to 2018 and 2019, has been far more pronounced. Such increased expectations make the FOMC less likely to cut interest rates before multiple additional months of CPI, PPI, and PCE data are available (barring a sharp deterioration of the job market). I'll be curious if the ruling of the Reciprocal and Trafficking tariffs as unconstitutional has any effect. #economics #markets #supplychain #ecommerce #freight

We’ve updated our #rate forecasts post-election, based on three main assumptions: 1) The #Fed will continue cutting rates, but may proceed more cautiously and maintain some optionality along the way; 2) The economy will continue to grow around trend near term; 3) A Republican sweep raises the prospects of fiscal expansion, which increases growth and inflation expectations. We still believe the direction of travel for interest rates is lower as any policy changes will likely take time to be finalized and implemented, the labor market continues to loosen, and the terminal rate has already repriced higher. But we now see the 10-year US Treasury yield trending towards 4% by June 2025, up from our previous forecast of 3.5%. Read more below.

Had the pleasure (stress) of doing two slots on BBC TV this morning: one before the inflation stats came out and one after. Luckily (for me) my forecast of a jump to 3.5% came in. My general take is that, while consumers will be feeling the pain for the next couple of months, the jump in headline inflation isn't as bad for the MPC and the outlook for interest rates as it first appears. The bulk of the increase was due to base effects in energy prices, which added over half a point. Increases in regulated prices like water and sewage and tax increases like vehicle excise duty added only a little less. Finally, the late Easter caused a surge in airfares and holiday prices. None of these will be particularly worrying for the MPC as they won't be repeated next year. In fact, there wasn't much sign of firms aggressively passing through the increase in employment costs. Clothes prices fell and hospitality inflation was surprisingly soft, although food price inflation did accelerate. Looking ahead, we expect inflation to hover around 3.5% for the rest of the year before dropping back to around 2.5% this time in 2026. Given that is already what the Bank of England is expecting, we think the MPC will continue with its "gradual and cautious" pace of quarterly rate cuts. However, given the recent split on the committee and some hawkish comments, the risks are slanted towards just one more cut this year. #RSMUK #RealEconomy #Inflation #InterestRates https://lnkd.in/eVs5zk8x

Why Has the Fed Cut Interest Rates by 0.5% While the Bank of England Held Steady? The recent decision by the Federal Reserve to cut interest rates by 0.5% while the Bank of England has chosen to keep rates unchanged highlights a key difference in how these central banks approach their economic responsibilities. Although both are tasked with maintaining financial stability, their mandates and priorities diverge, leading to different strategies in response to similar economic conditions. The BoE’s primary mandate is to manage inflation, thereby ensuring price stability by keeping inflation around its 2% target. In recent times, the UK has experienced inflationary pressures, partly driven by supply chain disruptions, rising energy prices, and other global factors. By the BoE holding rates steady, they signall that controlling inflation is more important than short-term economic growth. This conservative stance reflects the view that failing to address high inflation could lead to greater economic instability in the long run. In the BoE’s framework, the priority is clear: inflation management comes first, and the focus is on preventing inflation from spiralling out of control. Growth is a secondary consideration. Therefore, even if growth slows down or there are concerns about a potential economic downturn, the BoE’s stance remains firmly centred on inflation control, as persistent inflation can erode purchasing power and destabilise the broader economy. A cut in interest rates would risk fuelling inflation further, which the BoE sees as too high a cost to bear at present. On the other hand, the Fed operates under a dual mandate. This means the Fed must balance two equally important objectives: keeping inflation stable while also promoting maximum employment and economic growth. With this dual mandate, the Fed has a more flexible approach, as it is required to support economic activity while keeping an eye on inflation. In the current environment, the Fed has seen signs that US economic growth is weakening—whether due to slowing demand, challenges in the labour market, or external global pressures. Although inflation remains a concern, the Fed judged that an interest rate cut was necessary to prevent a significant economic slowdown. By cutting rates, the Fed aims to encourage borrowing, investment, and spending, which can help stimulate economic growth and support employment levels. This decision reflects the Fed’s broader remit to foster conditions that promote both stable prices and robust economic activity. The 0.5% rate cut, therefore, is not just a reaction to inflation but also a pre-emptive measure to avoid a potential recession or economic stagnation. Therefore, the difference in response is likely due to diverging mandates. The BoE, focused almost entirely on controlling inflation, therefore keeps rates steady to prevent further inflation. But, the Fed is balancing inflation concerns and economic growth/employment, so cuts rates.

This week’s inflation report, though market constructive, continued to underscore the bifurcation taking place between the goods and services sectors of the economy. Key things to note:   *While services inflation remains high in absolute terms, its growth is now downward sloping and is helping to keep core CPI contained. See below, but our forecast is that real incomes are starting to turn positive across a wider swath of U.S. consumers. That is a good thing. That said, we are not out of the woods yet as we expect continued volatility in goods inflation in the coming months, driven by tariffs, wildfires, and outbreaks of bird flu.   *In light of these upward pressures on goods prices, we have adjusted our 2025 headline CPI forecast slightly to 2.8%, up from 2.6% (vs. consensus of 2.5%). Importantly, Fed tightenings and easings are not affecting financial conditions as much as in the past. Key to our thinking is that many of the big corporate capex spenders don’t have as much debt on their balance sheet this cycle. On the interest rate front, we stick with two cuts this year, while we expect the 10-year to trade in the 4.5-4.75% range.    Bigger picture, while our Regime Change thesis does not foresee runaway inflation, we still see a higher resting heart rate this cycle, marked by increased variability due to 1) larger deficits; 2) geopolitical tensions; 3) a complex energy transition; and 4) persistent inflationary trends. At KKR we spend time on longer-term trends, which suggest the following mega-themes:   1. Productivity Enhancements: As input costs, including wages, rise, companies will increasingly prioritize resource allocation toward boosting productivity. 2. Capitalize on Diverse Opportunities: We are strategically targeting both capital-heavy and capital-light investments across sectors such as insurance, consumer receivables, and housing, as well as through corporate carve-outs, particularly in Private Equity and Infrastructure. 3. Supply Chain Resilience: Corporations are seeking greater resilience in global supply chains, emphasizing the security of data, transportation, water, and energy. As the global economy shifts toward more regional models, the need for investment in these areas could reach trillions of dollars. 4. Picks and Shovels of AI: We anticipate substantial government investment aimed at securing energy sources. The demand for data centers, pipelines, cooling technologies, and related services is set to grow significantly, driven by a mega-theme where nearly 25% of total tech capital expenditure originates from the Mag7. 5. Collateral-Backed Cash Flows: We remain positive on investments that generate collateral-based cash flows within Infra, Asset-Based Finance, certain Real Estate sectors, and specific Energy segments. In a rising nominal GDP environment, we expect these assets to appreciate in value, leading to potential multiple expansions across this thematic. Read more at https://go.kkr.com/42dBKkM

In the end, the Fed rate decision was hardly a surprise. Of course, it could’ve been a different story! At the start of the year, many analysts expected March would be the first rate cut. But the inflation and growth data have been hotter than expected since then. And that ended any hopes of early policy easing. Instead, it’s a ‘no change’ from Mr Powell and team. Three points are worth noting for investors : 1️⃣ First, how far are we from the first cut? At the Congressional testimony a few weeks ago, Chair Powell said “not far”. But he didn’t use that phrase today. Globally, central bankers are now more concerned that the ‘last mile’ of disinflation could be hard-going. So the Fed wants to stay data-dependent and retain maximum flexibility. That means that markets will remain ‘hyper-sensitive’ to inflation news. On the balance of the data, we still expect the first cut in June. And Mr Powell also told us that the pace of QT will slow “fairly soon”. 2️⃣ Second, the Fed shared the updated quarterly forecasts – ‘the dots’. In December, they had 3 cuts pencilled in for 2024 and they’ve retained that guidance. But many investors I speak to already assume 2-3 cuts. Something to ponder there. Just as important is the scenario for 2025. Back in September, the Fed assumed 4 further cuts. But they now guide for 3 rate cuts next year. Of course, there’s a wide range around that. But, if delivered, it would mean that the Fed funds rate only goes back to c 4% by the end of 2025 – by historic yardsticks, it would be a very gradual rate cutting cycle. Meanwhile, the Fed upgraded its growth forecasts (now expecting 2.1% GDP growth in 2024), and lowered the unemployment estimate. In other words, the projected scenario is the softest of soft landings. 3️⃣ Third, the long run. A key issue for investors is where interest rates ultimately settle. The Fed has nudged its assumption higher from 2.5% to 2.6%. But this estimate still looks too low - a legacy assumption from the economy of the 2010s. Today’s macro paradigm is different. A number of Fed officials have already talked about 3% or higher terminal rates. And I would expect the long-run assumption to continue to drift higher. No big surprises, but a few interesting tidbits, and a positive tone for investment markets to respond to. The big week for central bankers continues … #fed #economy #markets #investmentstrategy chart source = HSBC AM, Macrobond

Monetary policy purgatory The Federal Reserve meets this week to determine the course of monetary policy. Look for another hawkish pause as they fail to signal a cut in May, but internal discussion about a cut in June heats up. Recent data on inflation has not been good, while we have seen a divergence on the surveys on employment. The household survey has shown a much greater slowdown than the estabilishment survey, which goes out to firms. The response rate on the latter has been horrible as the entire economy has grown fatigued of surveys. This was a trend pre-pandemic but has only worsened since. Current data, including the high frequency data, shows that inflation has cooled but remains too hot. The labor market is cooling and even chilling in what were some of the hottest pandemic sectors - many overhired and are exporiencing whiplash as rates spike. We have been able to absorb many but not all of those jobs. The Fed will lean toward caution on cuts again, but there is a contingent that worries about the nonlinearity in labor markets conditions. When unemployment moves up, it tends to do so rapidly. Further complicating matters is the threat that the economy is more susceptible to shocks and the inflation they trigger than pre-pandemic. This is showing up in climate change damages and the rise in material costs to make repairs. Those have boosted insurance costs. Vehicle insurance is just catching up with the surge in maintenance and repair costs of the larger, more expensive vehicles we now buy. Many argue the Fed should not worry about supply shocks. However, we have seen periods where supply shocks became imbedded in expectations. Central banks are trying to figure out how to effectively navigate a more uneven post- pandemic inflation terrains. Bottom line: Fed will punt on a March or May cut, and not signal a imminent June cut. That doesn’t mean it won’t cut in June; it just means they still want the option not to, which is hard for all those waiting for a sign the Fed is done with its higher for longer experiment. The Fed also sees normalizing rates in absence of recession as a slow process. A rapid deteraion in the labor market would prompt more rapid cuts.