Investors on edge over the likelihood interest rate rises will continue longer than tipped

Investors are reassessing following central bank comments this week suggesting interest rates will be higher for longer in the US and Australia.

Traders on the floor of the New York Stock Exchange. Picture: Getty Images

Investors are on alert after economic data and central bank comments this week showed potential for interest rates to be higher for longer than expected in the US and Australia.

An upward reassessment of the US monetary policy outlook saw markets expect another 54 basis points of Fed hikes, to a peak of at least 5.00-5.25 per cent by July, versus 4.5-4.75 per cent now.

Expectations of US rate cuts in the second half of 2023 shrank from 50 to 21 basis points after a string of data backed the upbeat picture painted by the January non-farm payrolls report.

US consumer sentiment, inflation, retail sales, manufacturing, industrial production and jobless claims showed a resilient economy with more inflationary pressure than previously thought.

Fedspeak focused on the upside risk for US interest rates, with two officials (albeit non-voters) saying they had wanted to see a 50 bps hike this month rather than 25 bps.

That’s after 450 bps of rate hikes in the past 12 months to deal with persistent inflation.

US recession probabilities eased after the strong retail sales report, but the question is whether that adds to the risk of second-round inflation effects, leading to even higher US interest rates.

Australian consumer confidence dived to recessionary levels after the RBA said further increases in interest rates will be needed over the months ahead.

But business conditions rebounded to well-above average, with confidence also up, and wages and prices measures still showed considerable momentum despite the RBA’s big rate hikes last year.

Economists downplayed a potential signal from a weaker-than-expected January Labour Force Survey due to an exaggeration of seasonal effects after the pandemic. RBA officials told a similar story in their parliamentary testimony on Friday, while stressing the need to contain inflation.

Bond yields consequently remained under upward pressure.

The US 2-year yield hit a more than three-month high close of 4.68 per cent, and Australia’s 3-year bond yield in Australia hit a seven-week intraday high of 3.55 per cent.

The US 10-year bond yield hit a three-month-high close of 3.89 per cent.

Australia’s 10-year hit a six-week intraday high of 3.83 per cent.

Shares reacted negatively, but not as much as one may have expected after strong gains this year.

Australia’s ASX 200 fell 1.2 per cent to a more than four-week low daily close of 7350 points.

The index has fallen 2.9 per cent in its first two-week fall so far this year.

The US S&P 500 was flat as of Thursday, having jumped earlier in the week as the consumer confidence and retail sales data reduced recession fears. But the benchmark fell 1.4 per cent on Thursday and futures fell in Friday’s APAC session as investors pondered a potential “nightmare scenario” of stubbornly high US inflation causing much higher interest rates.

The recent large options bets on a 6 per cent Fed funds rate are starting to make more sense.

But while the major US equity strategists remain bearish, it’s worth taking a look at BofA’s latest Global Fund Manager Survey. It suggests that funds are already underweight.

BofA saw “no red light for risk assets” based on its February Global Fund Manager Survey.

The “pain trade” was still up, according to chief investment strategist, Michael Hartnett.

The survey did find that investor sentiment was at its least pessimistic since February 2022.

But investors were “nowhere near optimistic enough to say positioning is a ‘sell catalyst’.”

“Investors remain pessimistic in February but to a lesser degree, with all key measures of sentiment improving month-on-month and a shift in positioning highlighting stronger risk appetite,” Mr Hartnett said.

The average percentile rank of next 12-month growth expectations, cash allocation, and equity allocation improved in to their highest level points in a year.

Global recession odds sentiment peaked at 77 per cent in November, falling to 24 per cent this month, the lowest since June. Prior peaks in recession fears coincided with the start of major bull markets in asset prices, according to BofA’s Hartnett.

Cash as a percentage of assets under management slipped to 5.2 per cent.

That was well down on its October peak above 6 per cent, but only back down to the level it stood at just before the start of the Russia/Ukraine war a year ago.

Retail sentiment is bullish: the American Association of Independent Investors’ survey shows the percentage of bears at the lowest point since 2021, the CNN Fear/Greed index is at “Extreme Greed” and US financial conditions are the least restrictive in a year – and the bond market is pricing out the second half rate cuts that the share market was counting on.

But if BofA’s survey is an accurate reflection of institutional positioning, then any retail capitulation and sharp sell-off in shares is going to be snapped by fund managers.

Interestingly, BofA’s Asia Fund Manager Survey tells a different (bullish) story for the region.

Some 90 per cent of respondents saw a higher level in APAC ex-Japan equities in 12 months, with 68 per cent expecting the regional economy to strengthen, with China seen as the driver.