Federal reserve strategy, inflation expectations in the U.S. and Europe, investor behavior in the U.S. Where are we in the financial market cycle?

Chart of the week

The chart shows the key interest rates in the US (dark blue), Europe (light blue) and Switzerland (red).

Last week, the US and European central banks raised interest rates by a further 0.25%. In the US, key interest rates are now at their highest level in 22 years.
The U.S. Federal Reserve (FED) has raised interest rates the fastest and the most. The European central bank (ECB) was much more hesitant.  But it also has to worry that if interest rates are raised too much, the euro crisis will erupt anew and countries like Italy, Portugal and Spain will come close to national bankruptcy.

Why it matters
Key interest rates are one of the most important factors influencing the economy. Favorable interest rates lead to a lot of investment and stronger growth, whereas higher interest rates have exactly the opposite effect. Interest rates affect the economy with a lag of 6-12 months. This is what makes the job of central banks so difficult. Has the Fed raised interest rates too much and is the U.S. sliding into a major recession as a result?

The chart shows the gross domestic product (GDP) of the USA and Europe, adjusted for purchasing power, at constant prices, in trillions of dollars. GDP reflects the prosperity of the entire country. Over the past 20 years, the U.S. has massively increased its lead. Almost all technological innovation has come from the U.S. in recent years. Companies like Apple, Tesla, Netflix, Amazon and Google set the tone. The USA's more flexible central bank policy lays the foundation for this development.

Inflation expectations in the USA and Europe

The chart shows what investors expect in terms of inflation. Headline inflation (red) should fall steadily in the coming months. Around 2025, it should reach the target value of 2% defined by the US Federal Reserve.
The bars show the areas from which inflation is coming. As commodity, supply and production prices fall, most of the inflation comes from rising rents (light blue bars) and rising wages (gray bars). However, the situation is very fragile. If the U.S. economy does not cool down somewhat as desired, and if unemployment does not rise somewhat, this will lead to further increases in wages. The resulting rise in inflation would have to be combated with even higher interest rates. However, the majority of investors do not expect this to happen.

The chart shows which key interest rates investors expect to see in the next 12 meetings of the U.S. Federal Reserve. The highest probability is marked in blue. Most investors expect key interest rates to remain at the current level of 5.25% to 5.5% until next March. The first rate cut should come in May 2024.

But that doesn't mean now that growth companies that rely on cheap credit can breathe a sigh of relief. Many of the companies have borrowed for 6-12 months. So far, they have not been hit by the higher interest rates. But the longer interest rates remain at this high level, the more growth companies will have to refinance at the higher rates.

Because the Fed's decisions are so important, each member is analyzed in detail. In the process, the members are divided into three groups:

- Permanent voting members:
These largely collude and all vote the same as Jerome Powell the Federal Reserve Chairman.

- Hawks:
The non-permanent members who largely advocated an aggressive interest rate policy. They currently advocated for further increases in interest rates.

- Doves:
The non-permanent members who largely advocated a wait-and-see approach. Since interest rates affect the economy with a lag of 6-12 months, one should wait before raising interest rates further.

The chart shows in which years which non-permanent members of the Federal Reserve have voting rights (marked with "v"). In 2024, four members who currently have voting rights will be replaced. Bostic (Atlanta), Daly (San Fransico) and Mester (Cleeveland) are three representatives who are more on the hawkish side than their predecessors. Only with Barkin (Richmont) comes a representative who is slightly more on the side of the doves than his predecessor (Kashkarin).

So central bank policy could become a bit more aggressive in 2024 and side more with the hawks. Whether the first interest rate cut will come as early as May 2024, and not later, remains to be seen.

As far as inflation in Europe is concerned, expectations are roughly the same. Production costs (PPI), which are a good leading indicator for inflation (CPI), are falling sharply. Therefore, the ECB will probably not have to raise interest rates much further either, unless wages continue to rise.

Investor behavior in the USA

The chart shows the money flows since one year into the individual sectors of the US stock market. The inflow of additional money into the technology sector was and still is huge. Whereas the energy sector is being shunned by more and more investors. This discrepancy between the two sectors is unusually high. Money flows from the energy and commodity sectors seem to be stabilizing somewhat. It can be assumed that the inflows into the technology sector will also decrease soon.

The chart shows the average return of companies when quarterly results are announced, the next day on the stock market. Companies that surprise positively (dark blue) are rewarded, but companies that disappoint are punished massively.

Many investors always try to include the best stocks in their portfolio, the big winners. However, the better tactic in the long run is not to focus on the winners, but to avoid the losers. This also leads to not blindly chasing every trend and usually being too late. Such tactics lead to more stable and higher returns.
Letting oneself be guided by trends and the majority always ensures that principles are thrown overboard. The worst case is when a colleague, whom one knows well, has made a lot of money with the trend. Then many forget every risk principle that they otherwise consistently follow.

At the moment, there is a great lack of concern on the stock markets. It seems that the central banks have everything under control as never before. This is because the expected recession simply doesn't want to come. You can already read the headlines "The recession is canceled.

The chart symbolizes this carelessness. It shows the costs that an investor has to pay if he hedges his portfolio against falling prices (with put options) over a period of one year. These costs are lower than at any time in the past 15 years.

One of the most important factors influencing the premium of options is volatility; that is, very small fluctuations in prices. Investment professionals see this as a warning signal.

Where do we stand in the financial market cycle

The chart shows the four phases in a financial market cycle that lasts for years. We think we have been in the fourth phase for months. Investors are focusing on quality companies with a proven business model and stable earnings.
Since some are assuming that there will be no more recession, or that it has already passed, the question is whether we are now already moving into phase one of the cycle. In other words, whether it is now time to switch from large cap stocks to small cap stocks.

The chart shows the number of long futures positions (green bars) in the S&P 500, i.e. the index for very large companies. The number is in positive territory and continues to increase. This means that investors are still betting on this segment. Also, the level of all long positions is still below the level of 2021, before the trend reversal occurred.

The chart shows the number of long futures positions (green bars) in the Russell 2000, the best-known index for small companies in the USA (small and mid caps). The price trend of the index is shown in dark blue. There are signs that prices are stabilizing, but it is questionable whether we are already seeing a turnaround here. In any case, it is positive that the number of short positions in the futures (green bars in the negative area) has dissolved.
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From our point of view, we still remain in phase four (downturn). It is still too early for a transition to phase one.  

Marmot also goes on vacation
Usually, there is not much going on in the markets during the summer months. Volumes are low and the central banks, do not meet again until September. We also use this time to take a break. In the next 2-3 weeks, we report only if the outlook on the markets fundamentally changes.