Are the central banks making a double mistake?

It took the central banks a very long time to realize that the inflation that flared up at the beginning of 2021 was not just temporary. It was not until a year later that they began to fight inflation by raising interest rates (charts 1a and b). There are now increasingly clear signs of a coming recession, but the central banks want to continue raising money market interest rates, which are already higher than the interest rates on 10-year government bonds. Will the central banks miss the next turnaround? What does this mean for investors?

The central banks in the USA and the eurozone cite low unemployment, which is an indication of a strong economy, as one of the reasons for the planned further interest rate hikes. However, a closer look reveals that for 70 years, unemployment in the USA has only risen after the start of a recession. If you wait for the unemployment rate to rise significantly before lowering interest rates to avoid a recession, you are always acting too late.

With the exception of the mini-recession at the beginning of 2003, the course of events in the eurozone was exactly the same (chart 3). If we look at leading indicators such as the willingness of banks in the eurozone to lend in order to assess economic strength (chart 4), we can see that the economy will weaken very soon. The increasingly tighter lending conditions are an indication that the number of people in employment is likely to fall in 12 months' time and that the risk of recession will therefore increase. If there are fewer loans, fewer people will buy or invest.

The ECB also refers to the core inflation rate, which does not include energy and food prices in its calculations because these cannot be combated by raising interest rates. Unlike the overall inflation rate (e.g. Germany, chart 1a), the core inflation rate has not yet begun a downward trend. However, if we look at the change in the energy price index for the eurozone, there are signs that the core inflation rate is already falling significantly this summer with a 6-month time lag (chart 5, green line). Its emphasis on low unemployment and the high core inflation rate as a reason for further interest rate hikes increases the likelihood that the ECB will continue to raise interest rates for the fourth time since it took office 25 years ago, while economic growth rates are already falling significantly (red circles in chart 6), only to have to cut interest rates again soon after due to the further decline in economic growth.

The fact that the money supply has been shrinking for the first time in the ECB's history over the past few months also points to a weakening of the economy over the next 12 months (chart 7). The same correlation between a decline in money supply growth and a subsequent recession has existed in the US for 60 years (chart 8).

However, the most reliable early indicator of a recession in the USA for the past 70 years has been the interest rate structure, i.e. the difference between the interest rates on long-term and short-term government bonds (chart 9). Banks usually grant loans with a term of several years and fixed interest rates. These loans are financed by savings deposits and other credit balances of bank customers, by deposits from other banks and by loans from the central bank. However, the term of these deposits is usually shorter than that of the loans. If the short-term interest rate suddenly shoots up and exceeds the interest rate on 10-year government bonds (chart 1b), deposits become more expensive and the multi-year loan with a fixed interest rate becomes unprofitable. As a result, banks are less willing to lend in times of high short-term interest rates.

Chart 10 shows that many US banks are currently tightening their lending conditions. Historically, a high proportion of banks (currently 46%) have only done this in the last 33 years directly before or during a recession.

If the interest rate structure has a strong influence on bank lending and the emergence of a recession, it could also have a direct impact on some capital markets. For the US equity market, there is a clear correlation between a strongly inverted interest rate structure, in which the interest rate for 1-year government bonds exceeds that for 10-year bonds by more than 1 percentage point at times, and below-average share price performance (chart 11, red lines). In the 4 periods in which this condition was met (March 1973, March 1974, September 1978 and September 1980), the price performance of the US equity market was between 12 percentage points (from Sept. 1978) and 54 percentage points (from March 1973, 1st oil crisis) below the long-term average (blue line). The interest rate structure has also been strongly inverted since July 2022; share prices have again underperformed since then.

On the German (chart 12) and European stock markets (chart 13), the impact of a strongly inverse interest rate structure has been less negative than in the USA since 1970. A slightly inverse interest rate structure had no negative impact on share prices in Germany and Europe; a slightly negative effect can be seen in the USA. As the interest rate structure in Germany (since November 2022) and in Europe (from February 2023) has only become slightly inverted, there is no increased price risk for the equity markets in the coming months, unlike in the USA.

The US equity market has also now reached a dangerously high valuation level again (chart 14a), with only very low total annual returns of around 2% p.a. over the next 10 years in recent decades (chart 14b). 10-year US government bonds are significantly more attractive with a current yield of 3.7% p.a. (source: Trading Economics, May 2023).

In Europe, on the other hand, the valuation level is significantly lower (chart 15a) and the earnings expectations for the next 10 years are much higher than in the USA at over 8% p.a. (chart 15b).

In the past, gold and German residential real estate have even benefited from a strongly inverted interest rate structure (charts 16 and 17).

This confirms their reputation as forms of investment that protect against inflation, as a strongly inverse interest rate structure only existed in the USA during the period of high inflation rates from 1970 to 1981 and from 2022 (chart 18). In Germany, there was also a strongly inverse interest rate structure in the early 1990s, as the boom following German reunification forced the German Bundesbank to pursue a restrictive monetary policy to prevent a rise in inflation. Even in the current phase of an inverse interest rate structure, the outlook for gold and German residential real estate remains positive (see capital market outlook from February 2023, which you can find here ).

Finally, we look at the influence of an inverse interest rate structure on interest rate trends. For both the USA (since 1953) and Germany, a strongly inverse interest rate structure results in somewhat stronger interest rate increases or weaker interest rate cuts than a slightly inverse interest rate structure. With the exception of the development of 10-year US interest rates, the latter had led to a significant fall in interest rates within two years. In Germany, interest rates fell after two years even with a strongly inverse interest rate structure. Following the interest rate rises in recent months (dashed lines in all 4 charts), stagnation or a slight decline would now be more likely than a further rise in the pattern of recent decades, especially as an inverse interest rate structure normally results in a recession and could also produce this result this time.

Central banks have raised money market interest rates sharply in recent months, although a growing number of early indicators (tightening of lending conditions, falling money supply, inverse interest rate structure) point to a recession and an imminent fall in inflation rates (e.g. energy price index in Europe). Central bankers on both sides of the Atlantic want to raise interest rates further on the grounds that low unemployment and the high core inflation rate indicate a strong economy. However, these two key figures are unsuitable as lagging indicators for forecasting future economic development.

The inverse interest rate structure that has formed in this environment in recent months could be particularly problematic for the US equity market. With interest rates on 1-year government bonds almost 1.4 percentage points higher than interest rates on 10-year US government bonds, the interest rate structure there is more inverse than it has been for over 40 years. In the past, however, a strongly inverse interest rate structure has led to a significantly below-average price performance on the US equity market. In addition, the valuation of US equities is very high and no longer reflects the considerable economic risks. The risk of a price slump is much lower for European equities, as their valuation is not overpriced and, unlike in the USA, the expected return of 8% p.a. for the next 10 years is far higher than the yield on government bonds. In addition, the interest rate structure in Europe and Germany is only slightly inverse, which has not led to below-average price performance on the stock market in the past. In the case of gold and residential real estate in Germany, too, the interest rate structure does not indicate any negative development in the future. Interest rates in Europe and the USA should not be able to rise much further, so that significant price losses on the stock market, which can occur at the beginning of a recession, should be used to buy additional shares.  

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Capital market review: May 2020, which you can find here

The core statements 3 years ago were:

The sharp rise in government debt as a result of the coronavirus aid measures will not be reduced through savings in the coming years. Interest rates will be kept as low as possible by continuing to print money. As soon as the economy recovers, inflation rates will rise.

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You can also download the capital market outlook here.

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