(Bloomberg) — All of a sudden, the prospect of US rates hitting 6% is becoming real enough for investors to rethink their strategies.
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BlackRock Inc. and Schroders Plc are among those who are weighing in on the debate of what will happen if US rates peak at 6%. As late as end-February, investors across bonds, stocks and currency markets were still calling for an end to higher rates with bets for a broad rally in the second half.
Instead, Federal Reserve Chair Jerome Powell’s testimony on Tuesday is fueling expectations of a bigger hike this month, with traders pricing in peak rates of 5.6% from less than 5% at the end of last year. Treasury traders are doubling down on recession expectations, the dollar has rebounded while equity markets from the S&P 500 Index to the MSCI Asia Pacific gauge are giving up gains.
Given the robust job market and sticky inflation, “we think there’s a reasonable chance that the Fed will have to bring the Fed Funds rate to 6%, and then keep it there for an extended period to slow the economy and get inflation down to near 2%,” Rick Rieder, chief investment officer for global fixed income at BlackRock, said in a Tuesday note.
The Federal Reserve’s latest messaging sets the stage for the central bank to revert to a half-point hike, and stands in marked contrast to the softer stance adopted by peers in Australia and Canada. It’s also fueling fears of a hard landing for the US economy as the bond market telegraphs the growing odds of a recession.
Swaps traders are now pricing in a full percentage point of Fed hikes over the next four meetings.
“A 6% terminal rate is not out of the question now,” said Kellie Wood, deputy head of fixed income at Schroders Plc in Australia. “Expect to see a broad-based selloff in Aussie and Asian markets today led by the short end but with US rates underperforming.”
In the US, the spread between 2- and 10-year yields are showing a discount larger than a percentage point for the first time since 1981, when then-Fed Chair Paul Volcker was pushing through hikes to tackle double-digit inflation. The yield inversion indicator has over the decades anticipated recessions in the wake of aggressive Fed tightening campaigns.
Commodity currencies have retreated as the prospects of a US recession grow, with the Australian dollar sinking 2% on Tuesday. The Bloomberg Dollar Spot Index climbed to the highest since early January on Wednesday after rallying 1% the previous day. The yen is once again closing in on the 140 level against the greenback.
“Before Powell last night, we were more inclined to try shorting USD/JPY around the 137-138 level — think we would probably hold off on that, with Fed terminal rates very possibly heading to 6%,” said John Bromhead, a currency strategist at Australia & New Zealand Banking Group Ltd.
Credit markets are similarly bracing for the fallout from the repricing of US rates.
“It’s not our base case, but a 6% Fed Funds rate would likely result in a stronger dollar, weaker global growth and ultimately downside for risk asset valuations,” said Mark Reade, head of fixed-income desk research at Mizuho Securities Asia. “While China’s reopening and a relative scarcity of new supply would likely cushion the blow for Chinese USD bond spreads, it is unlikely those spreads emerge unscathed.”
The Fed rhetoric risks worsening the outlook for emerging-market assets, after Beijing’s modest economic growth target earlier this week dashed hopes of a resumption of the reopening rally that buoyed global markets earlier. The South Korean won, a proxy for risk sentiment in Asia, sank 1.8% on Wednesday.
“Higher-for-longer is becoming the base-case scenario, and if that scenario materializes, EM can suffer,” said Brendan McKenna, emerging markets strategist at Wells Fargo in New York. “Markets were really hoping for an early Fed pause and cuts this year, so far that scenario is not unfolding.”
Still, some investors see buying opportunities in the stock market.
“We would expect the more cyclical and cheaper markets of North Asia to be favored and rotation away from South Asia to continue,” said Sat Duhra, fund manager at Janus Henderson Investors. “Finally the higher quality tech names in North Asia, in particular semiconductors, are beginning to appear attractive on valuation and is a sector that should fully participate in any recovery in earnings.”
–With assistance from Liz Capo McCormick, Ishika Mookerjee, Georgina Mckay, Matthew Burgess and Wei Zhou.
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