JP Morgan CEO Jamie Dimon’s warning of 7% US interest rates may appear extreme but it is certainly within the realms of possibility.
Consensus over the direction of US interest rates has changed dramatically this year amid stubborn inflation and stronger-than-expected growth. At the start of the year, markets were calling the Fed’s bluff by pricing in rate cuts, something chair Jerome Powell baulked at in March.
The mantra ‘do not fight the Fed’ once again came true as markets shifted from pricing in a 7.3% chance of the Fed not cutting rates to a 37.5% chance of a further rate hike by the end of the year. This ‘higher-for-longer’ narrative – which is now gripping investors – has driven 10-year US Treasury yields to 16-year highs.
“The worst case is 7% with stagflation,” Dimon told The Times of India, “If [businesses] are going to have lower volumes and higher rates, there will be stress in the system. We urge clients to be prepared for that kind of stress.”
Dimon has a point. The reason investors should prepare for higher interest rates is due to a structural trend taking place across western economies.
That is the concept that the ageing population has created a shrinking US workforce that is driving labour shortages which could force the Fed to keep interest rates at elevated levels.
“Central banks need to keep a lid on growth to avoid resurgent inflation once pandemic-era mismatches unwind,” BlackRock said. “That is why we see them holding tight, not cutting rates like they did in past slowdowns.”
According to BlackRock, these market forces are creating a new thesis – full-employment stagnation – the concept of the Fed being forced to increase rates as unemployment rates refuse to budge from current levels.
“A smaller workforce means the rate of growth the economy will be able to sustain without resurgent inflation will be lower than in the past,” Wei Li, global chief investment strategist at the BlackRock Investment Institute, said.
“We see central banks being forced to keep policy tight to lean against inflationary pressures. This is not a friendly backdrop for broad asset class returns, marking a break from the four decades of steady growth and inflation known as the ‘Great Moderation’.”
In this scenario of structurally higher inflation, short-duration US Treasury ETFs will play an essential role in fund selectors’ portfolios.
While ‘higher-for-longer’ has become the consensus view, stronger growth in the US will force the Fed to keep rates even higher than market expectations.
In this environment, investors will need to take risk off the table by hunkering down in the front end of the US Treasury yield curve. This will provide the necessary protection, especially if Dimon’s worst-case scenario comes true.