Rate-hike aftermath is not risk-free
Unsurprisingly the US Federal Reserve raised its Federal Funds Rate by 25 bps to 5.25% on May 3, hinting that this could be the last rate hike for a while. During the press conference, US Federal Reserve Board chairman Jerome Powell said that future moves would be “data dependent”. Key to the less hawkish tone is the lagged and ongoing effect of tighter credit conditions, which are accelerating after the recent shocks to the banking sector.
“Despite the non-committal guidance offered today, we think this will be the last rate hike of the cycle — particularly since the debt-ceiling impasse may have reached a crisis point by the time of the June meeting. Looking ahead, we expect the US Fed will cut the policy rate by 75 bps starting in 4Q2023 once the labour market confirms that the economy has softened markedly and that inflation pressure is receding towards the Fed’s target,” write PGIM Fixed Income’s Daleep Singh, chief global economist, head of global macroeconomic research, and Robert Tipp, chief investment strategist, head of global bonds.
When the 10-year US Treasury yield hit its intraday peak of 4.34% in October 2022, the markets essentially cast their vote: rates have gone far enough and it is just a matter of time until the Fed pivots from hikes to cuts, Singh and Tipp add. “Current market pricing shows more than 200 bps of rate cuts by the second half of 2024 as a mean expectation,” they estimate.
The rate cut scenario incorporates a recession. “In our judgment, a mild recession remains the most likely macroeconomic scenario over the next 12 months, though we continue to see an appreciable chance of continued expansion if the Fed takes its foot off the brakes in a timely manner,” Singh and Tipp state.
Ray Sharma-Ong, investment director, multi-asset investment solutions, at abrdn, says: “We do not think the banking sector issues will be systemic but the tightening of credit conditions will weigh heavily on economic activity, and we expect a recession in the US to occur in the 2H2023. We expect the Fed to cut rates when a recession occurs.”
Recession on the horizon to trigger a rate cut sounds rather ominious. Still DBS Group Research sounds relieved as a Fed pause could be positive for S-REITs. “We reiterate that a Fed pause will be a net positive for the S-REITs. Our preferred sectors are retail and industrial. our stock picks are CapitaLand Ascott Trust and CDL Hospitality Trusts for hotels; Frasers Centrepoint Trust and Lendlease Global Commercial REIT for retail; and CapitaLand Ascendas REIT, Frasers Logistics and Commercial Trust for industrial.”
On the equity front, Keppel Corp reacted positively initially to its restructure. Interestingly, the new model’s reliance on AUM, AUM growth, and fee income places Keppel at the mercy of capital partners, in some cases the capital markets — eg Keppel Infrastructure Trust’s equity fundraising — and more often than not at the vagaries of the interest rate cycle.
Sembcorp Industries’ (SCI) share price surge could point to it moving in the same direction as Keppel. SCI has the potential to lower its gearing by creating either private equity funds and publicly-listed infrastructure trusts when capital partners and markets are amenable.
Is the brave new world all about fees? A banker once remarked — when his bank was increasingly focused on wealth management — that wealth management fees are the holy grail of banking. Fee income for banks provide them with higher ROEs as they do not need to set aside as much capital compared to bank lending.
After all, asset-liability mismanagement is likely to be partly blamed for the unwinding of US regional banks such as Silicon Valley Bank and First Republic Bank. Of course, private banks have not been without problems either. Essentially, nothing is really risk-free, especially not the prospect of lower interest rates.