2 FEB, 2023
By RankiaPro Europe
The Fed decided to raise interest rates by 0.25% after its two-day meeting. Jerome Powell, chairman of the US Federal Reserve, said that the rate hike would continue next month as long as the fight against inflation persists. The market expected the central bank's decision and reacted well to the news. Here are the conclusions drawn by fund managers' experts after yesterday's announcement.
The big criticism of the Fed this time last year was that it had fallen behind the curve, after being blindsided by surging inflation. After a series of outsized interest rate hikes, today’s more familiar feeling 25bps move shows a central bank more comfortable with where its policy stance sits at present.
Certainly, the Fed will be encouraged by some signs of slowing inflation, but the job remains far from done. The Fed continues to signal that a series of ongoing rate hikes will be needed to drag price growth to target as the central bank pushes back against a market keen to price in a soft landing and interest rate cuts later this year. We think the Fed only has one more hike left in the tank with a recession around the middle of the year to derail its tightening cycle.
As universally expected, the Fed increased policy rates by 25 basis points, stepping further back from jumbo-sized 75 and 50 basis points rises at a time when inflation is showing signs of cooling. But once again that was most likely not the main motivation for the central bankers’ shift. The time lag with which monetary policy impacts the economy was most likely the main reason for doing less again in the first meeting of 2023. Usually, rate hikes are thought to need between three and four quarters to fully show their effect on the economy. This consideration is taking on increasing importance for the FOMC as labor markets remain remarkably resilient nine months after the start of this rate hike cycle and might imply a “wait-and-see” attitude, soon.
Today’s statement reflects this. The central bankers decided not to modify their guidance on further rate hikes as some had speculated. The phrase “ongoing increases in the target range will be appropriate” was untouched and signals the Fed’s willingness to further tighten monetary policy. Despite this hawkish forward guidance, the current interest rate level of 4.50-4.75 is not far from the often-mentioned desired peak of “above 5 percent”. But in the press conference, Fed Chair Jerome Powell once again mentioned the elephant in the room: an “extremely tight labor market” that “continues to be out of balance”. He added that inflation remains too high and that the Fed needs to remain restrictive for some time.
Overall, however, Fed Chair Jerome Powell once again pushed back on market expectations of possible rate cuts this year but at the same time signaled a possible end of the hiking cycle by reaffirming December’s outlook on a terminal rate of somewhat above 5 percent. This is in line with our expectations, but we should keep in mind that the Fed now has a prolonged timeframe until the next meeting in March. Lots of data-points on labor markets and inflation are due before then. We do not expect the Fed to be ready to pause in March and another 25 basis point hike then remains highly likely, but an ongoing downturn in economic activity could change the situation thereafter.
Though economic slowdown might make the case for a pause in the May meeting, a lot of easing in the labor markets is needed before the Fed is likely to prove willing to cut rates. The market hopes for this in 2023. We would not expect it until early 2024.
The latest skirmish in the ongoing tug-of-war between financial markets and the Federal Reserve (Fed) occurred on February 1, with the latter party reaffirming its hawkish stance. This largely followed the plot established in late 2022, when a rally in bonds and riskier assets that was premised on the Fed ultimately relenting was only briefly interrupted by the Fed’s hawkish December statement. Should the market again either ignore or misinterpret the Fed’s resolve, we believe investors may be setting themselves up for what could be an inevitable – and potentially painful – reckoning.
This meeting’s 25 basis-point (bps) rate increase was already baked into asset prices. What the market may have a hard time digesting is the continued inclusion in the Fed’s statement of the phrase “ongoing rate increases will be appropriate.” Open to interpretation is how long the fed funds rate will remain at its cycle peak once we get there.
At its December meeting, the Fed’s own Dots survey indicated that the upper limit of the overnight rate’s range would finish 2023 at 5.25%. That represents potentially two more 25 bps increases. Both the Fed and the market presume that any more hikes will come sooner rather than later. The futures market, however, expects the fed funds rate to peak at roughly 5.00% in July before falling to 4.50% by year’s end. That’s quite a discrepancy and, in our view, sets up a fairly precarious game of chicken.
The conclusion of this story is yet to be written. Implicit in that unknown is a word of caution for investors: As the Fed’s and the market’s expectations further diverge, the risk of someone getting caught offside rises considerably. So, while we expect rates markets – and other asset classes – to trade in a range-bound manner in the coming months, as the true path of the economy emerges, we would not be surprised to see a spike in volatility as the market adjusts to a yet-to-be-determined reality.
Our view, given the tightness of the U.S. labor market, is that the Fed will have to do more than the market expects to subdue inflation. As we’ve stated in the past, pause does not equally pivot. And while a second successive 25 bps increase signals that we are nearing the end of this rate-hiking cycle, we are not there yet. That will be determined – as has been the Powell Fed’s practice – by the data.
Accordingly, we think the market doves will likely have to adjust their expectations. Should rates stay on the Fed’s more aggressive path, we would expect to see yields on the shortest-dated U.S. Treasuries most influenced by Fed policy creep up to account for a fed funds rate peaking higher than 5.0%. Such an outcome would likely send longer-dated yields lower as investors price in an, even more, material economic slowdown. Should this scenario unfold, we believe that bond investors could eventually increase portfolio duration with the aim of capturing capital appreciation.
Again, we are not there yet. But with yields having reset at materially higher levels, we believe investors can afford to be patient and earn income streams that had been unimaginable on shorter-duration securities only a year ago. The pronounced inversion of the yield curve – with the yield on 2-year U.S. Treasuries roughly 70 bps higher than that of the 10-year – further underpins the view that the time to extend duration has yet to arrive.
Markets welcome a dovish pivot earlier than expected. The Fed raised rates by 25bps yesterday in line with market expectations. It wasn't so much the hike that was perceived as dovish but the statement that followed. It is clear the Fed is still focused on inflation but this is the most dovish tilt we have seen since the 2018/19 Fed pivot. It is also clear that we are closer to the end of the hiking cycle, but the data is split with this continuation of labour market strength giving more hope of a soft landing.
The ratio of job openings to unemployed rose back to 1.9 – a sign of continued strength in the labour market with job openings back to 11 million. If the Fed is truly data dependent, then Friday’s release of average hourly earnings and CPI will be interesting if they do not show what is expected. This may force the now dovish Fed to rethink their change in narrative.
Whilst Powell did say they needed “substantially more evidence that inflation is on a sustained downward path”, he didn’t push back on the possibility of 50bps cuts toward the end of 2023. These are in fact already priced into the market (along with a slightly lower terminal rate now at 4.9%). As I see this, the markets’ desperation for the duration trade is being gifted by a dovish Fed and this shift in overall narrative might just be telling us – once again – not to fight the Fed.
Meanwhile, the ECB and BOE decision today potentially mean further weakness for the USD, as the ECB has led markets to think it is still on a hawkish path. However, the decision reminds us of one more key thing - not to rely on forward guidance.
At its first meeting of 2023, the U.S. Federal Reserve (Fed) faced competing priorities: how to acknowledge the progress made on inflation – and signal that rate hikes won’t go on forever – while still maintaining a sufficiently restrictive stance of monetary policy as measured across a broad range of assets. Although Fed Chair Jerome Powell repeatedly emphasized the Fed’s resolve to “not stop before the job [on bringing down inflation is done,” his assessment of the risks of doing too much versus too little shifted toward a more balanced tone. Indeed, he even said that if inflation falls faster than the Fed’s current projections, there would be less need for restrictive policy and the Fed would also cut rates more quickly than it is currently projecting. These messages, coupled with Chair Powell’s interpretation of the current market pricing as reflecting a more benign inflation outlook than what the Fed is currently expecting, suggest that Chair Powell did not set out to aggressively realign market pricing with the Fed’s forecasts.
The Fed’s latest projections suggest it will hike twice more this year – i.e., 25 basis points at each of its next two meetings, in March and May. However, our assessment of Fed communications to date alongside our baseline for a modest recession leads us to expect one more 25 basis point (bp) rate hike in March before the Fed pauses, followed by gradual rate cuts beginning sometime in the second half of this year.
Interpreting the Fed’s guidance in light of macro developments
Little changed in the February Fed statement: Guidance on future rate hikes softened slightly from a focus on the pace of hikes to a focus on the extent of further hikes.
Following February’s 25-bp hike, the target range for the fed funds rate sits 50 bps below the median dot where Fed officials projected the rate could peak in 2023, according to the most recent (December) statement of economic projections, or SEP. However, markets are pricing the fed funds rate to end the year about 75 bps below the 2023 median dot.
This divergence between market pricing and Fed projections is part of the balancing act officials face amid economic data suggesting monetary policy tightening to date is cooling the economy against the risks stemming from inflation that is still too hot (and well above the Fed’s target). While Chair Powell tried to push back on the likelihood of rate cuts in 2023 barring a downside inflation surprise, he stopped short of clearly signaling an additional rate hike in May.
Since their last meeting in December, Fed policymakers heard further good news on U.S. inflation: Their preferred measure, core personal consumption expenditures (PCE), fell to 2.9% on a three-month annualized basis (per December data), while the latest employment reports suggest wage inflation may have peaked. Meanwhile, U.S. activity indicators have deteriorated, with consumption and manufacturing activity contracting in November and December.
Financial conditions in the U.S. have eased somewhat in light of recent positive CPI (Consumer Price Index) and PCE inflation reports – echoing similar trends in 2022 (for details, see this recent Viewpoint by Rich Clarida). With Fed officials continuing to see greater risk from doing too little to cool inflation versus doing too much, Chair Powell reaffirmed that the Fed plans to hike further as it seeks to keep financial conditions sufficiently tight.
Our forecast: One more hike
Nevertheless, given the recent weakening in various U.S. activity indicators, and the better inflation news, we believe the Fed’s pause isn’t far off. Indeed, if recent economic trends continue as we expect – we forecast a mild recession in the U.S. in 2023 – then the Fed should have enough data in hand at the March meeting to hike and signal a pause.
By RankiaPro Europe
By RankiaPro Europe