The week in the markets: where next for the Fed?

The main event this week is once again the interest rate announcement from the US Federal Reserve (Fed). Always a key focus, the US central bank’s thinking is more important than ever after a week in which investors eyed the prospect of higher inflation but lower growth - aka stagflation.

Higher for longer

The Fed’s task just got even harder. Navigating the US economy through the ups and downs of the economic cycle is never easy when the only tool at your disposal is the blunt instrument of interest rates. Moving the cost of borrowing has a big impact on the economy, but its force is variable and it works on an unpredictable timescale.

Things get even harder when different economic measures are pointing in opposite directions. Recently we learned that economic activity in America is weaker than we hoped but inflation is stronger. That’s a bad combination because the monetary policy measures that make sense to cure one problem only make the other one worse.

So, all eyes will be on the Fed this week. Not so much on what it does - nothing probably. More so on what it says, about the timing of the next rate change - and even whether that’s likely to be up or down. For the first time in a while, an increase in interest rates is back on the radar as America’s red hot labour market refuses to lie down.

Rippling through the markets

The consequences of the Fed’s dilemma are felt throughout financial markets. First of all, they have shown up in the bond market, where yields are rising (and prices falling) as investors factor in the higher for longer rate narrative.

Secondly, the dollar is continuing to rise against other currencies. This is particularly the case in Japan, which is sticking with its lower for longer policy regime. Against that backdrop, the yen looks increasingly friendless. A dollar buys 158 yen, the most for more than 30 years.

Unexpectedly, shares are holding up well in the face of higher bond yields. After pulling back by about 6% since the recent high in late March, shares have stabilised in the US. And in the UK, the commodity-heavy FTSE 100 has hit a new all-time high. In part the resilience of shares reflects continuing good news on the earnings front. More than half-way through the first quarter earnings season, 80% of results are better than forecast.

Ready for another supercycle?

One asset class that seems poised for a rebound is commodities. There’s a string of reasons why investors might expect the price of metals and energy to rise from here. Geo-political risk is high, which tends to push the price of oil and gas up, especially when the uncertainty is focused on the Middle East.

A rebound in activity in China, after a slower than expected emergence from Covid, raises demand for key metals like copper and iron ore. So, too, in a longer-term secular way, does the ongoing shift towards a net zero world. In the short run, making the world’s energy infrastructure more sustainable will require a lot of unsustainable mining.

Signs that we may be on the cusp of another upswing in commodity prices - they tend to happen every 30 years or so - include the recent outperformance of commodity-related equities over the commodities themselves. Another indicator is the recent bid from BHP Billiton for rival Anglo American. Investors are starting to see the value in this long out of favour asset class.