Economists are reading the statement put out during the US Federal Open Market Committee (FOMC) as “hawkish”.
US Federal Reserve (US Fed) chair Jerome Powell said that the Federal Reserve “still have some ways to go” in terms of interest-rate increases to combat inflation.
On Dec 15, the US Fed raised its policy rate by 50 basis points (bps), a move that was in line with market consensus.
In his post-FOMC press conference, Powell stated that the slowing interest rate hikes to the more traditional quarter percentage point increases from the next meeting could be an “appropriate strategy”, note the analysts at DBS Group Research, Taimur Baig, Eugene Leow, Philip Wee and Chang Wei Liang.
The next meeting is slated to take place between Jan 31, 2023, and Feb 1, 2023.
“We think there is a 30% chance that strong labour market and retail sales data would nudge the Fed into hiking by 50 bps in the next meeting as well, but still think the terminal rate in this cycle would be 5%,” the analysts write.
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“As inflation eases, even if not to 2% as preferred by the Fed, real interest would rise considerably next year, which could hurt economic growth and affect financial stability,” they add. “This is the key reason we expect the Fed to not push too far on pushing up nominal interest rates; the fixed income market is in agreement with us, as seen in the swap market pricing.”
While the US Fed can “take some comfort” in the slightly lower inflation without major setbacks in jobs and overall economic activity after a year of sharp rate hikes and sizeable quantitative tightening, the DBS analysts point out that the lags of monetary policy will likely result in “increased economic and financial market fragility next year”.
“But the odds of an orderly transition to that state has risen lately, thankfully,” they write.
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To DBS’s Leow, the Summary of Economic Projection (SEP) was more hawkish than the statement suggests.
“First, the dot plot indicated that only two members see a terminal rate of 5% while ten members see a terminal rate of 5.25%. There was a clear upward skew as several members see higher peaks of 5.5 to 5.75%. 100 bps of cuts featured for 2024,” he says.
Second, the SEP projected more economic pain for 2023, revising its GDP growth down to 0.5% from 1.2% previously. The unemployment rate estimate was also raised to 4.6% from 4.4% previously, consistent with the higher peak rates, Leow continues.
Finally, the Fed remains cautious on inflation.
“Despite the two latest consumer price index (CPI) prints surprising on the downside, personal consumption expenditures (PCE) and core PCE inflation projections got nudged higher to 3.1% and 3.5% respectively,” he adds.
Despite the hawkish posture by the Fed, Leow sees that the US central bank is beginning to “act less hawkish”.
That said, it is premature for policymakers to sound dovish at this point.
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“Data dependence is once again critical as the Fed downshifts. Another weak CPI print or meaningful weakness in the labour market might be sufficient to trigger another downshift to 25 bps at the next FOMC meeting (outcome due Feb 1, 2023). We would also note that the Fed left itself plenty of leeway to manoeuvre,” says Leow.
“Judging by the overall reaction in the rates space (two-year faded most of the intraday spike while 10-year yields ended lower on the day), it would appear that the market is also not convinced that the Fed can keep rates that high for that long,” he adds. “Futures still factor in a Fed terminal of below 5% and two cuts by end-2023.”
“Curve wise, the belly tenors (three-year to seven-year) performed well, triggering steepening in the five-year/30-year segment. The two-year/10-year segment steepened to -66 bps before the FOMC statement was released, and eventually flattened towards -74 bps given the Fed’s hawkish stance,” Leow says.
“We maintain our steepening bias in the (two-year/10-year and five-year/30-year) over the coming months, maintaining that a shift away from stagflation pricing is the most likely. We think that receive two-year/five-year/10-year fly (one of our favourite ideas) look a tad stretched at current levels,” he adds.
In foreign exchange (FX), DBS’s Philip Wee points out that the Dollar Index (DXY) fell 0.4% to 103.6 after the rate hike.
“Although the Fed projected a higher Fed Funds Rate (FFR) to 5.1% in 2023 from the 4.6% pencilled in September’s SEP, the US Treasury two-year yield eased 1 bps to 4.21% while the 10-year yield fell 2.4 bps to 3.477%,” he writes.
Further to the most recent rate hike, the Dow Jones Industrial Average, S&P 500 and the Nasdaq fell by 0.4%, 0.6%, and 0.8% respectively.
The SEP downgraded US growth in 2023 to 0.5% from 1.2%.
However, in Wee’s view, the Fed is likely to push back against the market’s bet for rate cuts in 2023 on a US recession.
“Real rates are still negative with the US PCE core deflator still high at 6% y-o-y in November,” he says.
UOB’s head of research Suan Teck Kin, rates strategist Victor Yong, as well as its global economics and markets research team are adjusting its terminal Fed Funds Target Rate (FFTR) level to 5.25% from 5% previously. The new estimate comes as the FFTR currently stands at 4.5% and with a 50 bps hike expected to come at the upcoming FOMC meeting in January or February 2023.
“We expect this terminal rate of 5.25% to last through 2023. The cumulative rate increases in 2022 amounted to 425 bps, with another 75 bps increase on the cards in the 1Q2023. It should be noted that these forecasts are subject to incoming data,” the team writes.
For the longer maturities, the UOB team’s 10-year US treasury view is “largely intact”.
“We continue to look for a rates peak between now and 1Q2023, with bond yields expected to close 2023 lower than where they began. This view is consistent with the downwardly revised GDP and employment scenarios in the Fed’s latest economic projections,” the team says.
“A downbeat 2023 is the market consensus, and on balance that may translate to a bond market that reprices harder for confirmation of negative growth outcomes while being relatively agnostic towards minor inflation upticks,” it adds.
In the next FOMC meeting, the team at UOB says the upcoming key data points to watch out for will be the November 2022 PCE deflator on Dec 23.
Greg Baker, the CEO of TD Ameritrade Singapore notes that the 50 bps increase was “largely expected”.
“Some analysts are now anticipating that interest rates will peak at slightly above 5% by mid-2023, and rate cuts will begin shortly after that. The reality is that the period between the final interest rate hike and any interest rate cut is likely to be longer than usual, as the Fed will want to make sure inflation is down sustainably before making any new moves,” he says.
Looking ahead in 2023, however, investors should not be “sanguine” or try to predict the trends that may impact the markets.
“Instead, they should consider if their personal or investing goals have changed since the start of this year, and re-position their portfolios according to their current risk tolerance. When 2023 comes, it would do investors well to remember that staying invested can often work better than trying to time the market, especially during periods of market volatility,” Baker says.
To DWS Group’s US economist Christian Scherrmann, the step back from the jumbo-sized 75 bps rate hikes was most likely attributable to the time lag with which monetary policy impacts the economy.
“Usually rate hikes are thought to need up to four quarters to fully show their effect on the economy. Therefore, today’s interest rate hike is aiming to exert influence at the end of 2023 – by which time inflation is expected to be on or near to a sustained path towards the central bank’s target of 2%,” says Scherrmann.
On the downgraded estimate for growth in 2023, the economist says the move does not necessarily imply a recession.
“But, depending on the path the economy takes, recession could be on the cards given that such low growth is forecast,” he says.
He adds, “[the] normalisation of monetary policy is only indicated by 2024 and beyond. But it is expected to happen very gradually as FOMC members intend to cut rates to 4.1% in 2024 and to 3.1% in 2025 – by which time inflation is finally expected to converge towards the Fed target.”
Referring to Powell’s comment that the labour markets are “very tight” and that the supply and demand for labour is unbalanced, Scherrmann notes that the Fed chair’s comments suggest that the Fed is not yet convinced that inflation is on a sustained downward path.
“Overall, and contrary to the hopes of many observers, Jay Powell did not open up room for any dovishness and seems to value the painful lessons the Fed learned during the 1970s and 1980s. Small wonder the markets’ initial reaction is one of disappointment,” he says.
Sonia Meskin, BNY Mellon’s head of US Macro, also sees the message from FOMC as “hawkish” and sees that the officials seem to move closer to calling a recession, even if openly forecasting one would be unusual for the FOMC.
“But recall their previously stated willingness to risk a recession if that’s what it takes to tame inflation,” Meskin points out.
“Of course, the recessionary risk currently expressed in the SEP is still mild given the less than 100 bps rise in the forecast unemployment rate, and the dispersion in unemployment projections still relatively low: the upper range peaks at 5%,” she says.
While inflation risks call for a higher terminal rate and that recession risks have risen, Meskin feels that the Fed may need to “tighten more than currently expected to keep growth below potential and tame wage and inflationary pressures”.
“This would be consistent with Vantage Point’s most likely scenario of a global recession,” she says.
With the labour market still remaining strong, Meskin says she remains “focused on inflationary pressures from the US services sector, despite an expected deceleration in goods consumption and prices”.
“The November CPI print showed some notable re-acceleration in “sticky” inflation components: rent of primary residence +0.8% m-o-m vs. +0.7% in October; owner equivalent rent +0.7% m-o-m vs +0.6% in October; personal care services +1.4% m-o-m vs 0.2% in October; recreation services 1.0% vs 0.8% in October,” she concludes.
