The US Federal Reserve’s move to raise interest rates by 25 basis points during the Federal Open Market Committee (FOMC) meeting on March 15 came as no surprise to analysts.
At the meeting, one of the members, St. Louis Fed president James Bullard, even voted for a 50 basis point rate hike, which chairman Jerome Powell did not rule out.
If core inflation, which is currently above 6% of the consumer price index (CPI) does not return to the Fed’s goal of 2%, a 50-basis point rate hike is likely, notes Bank of Singapore’s (BoS) chief economist Mansoor Mohi-uddin.
On March 21, Powell continued to turn more hawkish, warning that interest rates may need to see a further increase at upcoming Fed meetings.
To Mohi-uddin, Powell’s remarks thus “add upside risk to our forecast that the Fed will stick with 25bps rate increases at each remaining meeting of the year when raising the fed funds rate to 1.75-2.00%”.
Powell had also hinted that the Fed could begin quantitative tightening (QT) in May to ease inflationary pressures.
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Given the Fed’s resolve to cut inflation, Mohi-uddin is now expecting seven rate hikes this year from five increases before. He has, however, kept his estimates of seeing four rate hikes in 2023, the same.
"This implies [that] we see the fed funds interest rate reaching 2.75-3.00% by the end of next year, a steeper path of tightening to our previous forecasts,” writes the analyst in his March 17 report
It also implies that his 10-year treasury yield forecast at 2.35% over the next 12 months is likely to be hit earlier,” he adds.
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Under Mohi-uddin’s estimates, he also sees higher yields being headwinds for investors, although the 10-year treasures would need to breach 2.80% to 3.00% for the decades-long downtrend in yields to reverse to the detriment of risk assets.
In addition, yield curves are likely to flatten further and may invert temporarily but reopening from the pandemic will keep US growth firm and reduce the risks of stagflation this year.
“Lastly, the USD will benefit from the Fed hiking faster compared to other central banks”, says the economist.
Fed rates to raise increase at every meeting in 2022: DBS
To DBS Group Research’s chief economist Taimur Baig and senior rates strategist Eugene Leow, the developments at the FOMC meeting were “unsurprising” to global markets.
However, the analysts estimate headwinds may materialize for emerging markets (EMs) from a hawkish Fed, as has already been the case.
“But most Asian economies have undergone repeated stress tests with capital flow volatility in the past years, and have shown that their relatively improved reserves and external account position can handle episodes of risk on and off. As long as China’s macro risks are contained, Asia can navigate the Fed’s path,” they write in their March 17 report.
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The way they see it, the FOMC’s statement was “focused on price pressures and yet comfortable that higher interest rates and quantitative tightening won’t undermine the economic outlook materially”.
“The Fed’s statement and actions reflect no concern about stagflation, period,” write the analysts, who note that the Fed now expects the policy rate to be at 2.88% in 2023 and 2024.
“[This implies] restrictive monetary settings compared to the neutral of 2.375% (downwardly revised from 2.50%),” they add.
Furthermore, the median projections made by the members of the FOMC are “constructive” for the medium term, note the analysts from DBS.
“Real GDP growth of over 2% (i.e., above potential) is expected through 2024, with no worsening of labour market conditions and core inflation heading toward 2%. Are these reasonable? We think so, especially if inflation expectations remain anchored, which has been the case so far,” they write.
“The continued stability of inflation expectation would be a function of wage and goods price pressure to dissipate as pandemic related disruptions fade,” they continue. “These two developments will make or break US economic outlook in the coming quarters, and will make the difference between the Fed making steady progress toward normalisation or playing catch-up that will un-nerve the markets.”
To this end, Baig and Leow are expecting the Fed to raise their rates in every meeting this year, which is six times, and then four more times in 2023. This would take the Fed funds rate to 2% by end-2022 and 3% by end-2023.
“The improved balance sheet of the households and corporates, we think the US economy is capable of absorbing these hikes. An economy that is growing by over 2% in real terms should be able to live with a real positive interest rate of around 1%,” they write.
“These hikes will come with some risks for those with high leverage, will likely strengthen the growth-to-value narrative in the equity markets, and some degree of spread widening in the credit market is likely,” they add. “The cyclical strength of the economy is substantial though, from balance sheet to the jobs outlook. As reflected in the FOMC statement, these developments need not cause major dislocation to wealth, investment, or consumption.”
Finally, DBS’s Baig and Leow are neutral on rates, noting that the Fed and the market are in agreement on rates out to 2023.
“It would be more interesting to fade extremes (in either direction) when they do occur. We are somewhat wary on duration (10-year onwards) and think that the market may be underestimating QT (we think QT will start in the immediate two meetings) and the eventual selling of mortgage-backed securities or MBS (possible in 2023),” they write.
“We think that the curve might be overly flat in the short term and there is scope for modest steepening. However, in the medium term, a very flat (to inverted curve) towards the tail end of tightening (2H2023) is probably hard to avoid,” they add.
Cumulative basis point increases expected in 2022: UOB
UOB’s senior economist Alvin Liew says the FOMC meeting on March 15 to 16 was “visibly hawkish” as the Fed raised its rates by 25 basis points.
The Fed had also signalled that more rate hikes will follow with its focus on bringing inflation down.
“Given the explicit hawkish trajectory spelt out in the March FOMC, we now expect faster Fed Funds Target rate (FFTR) hikes by clips of 25 basis points in every remaining meeting of this year,” writes Liew in his March 17 report.
This implies a cumulative increase of 175 basis points in 2022, bringing the FFTR higher to the range of 1.75% to 2.00% by end of 2022, up from Liew’s previous forecast of 150 basis points in hikes to 1.50% to 1.75% by the end of the year.
“We also see a risk that the Fed could still surprise with a more aggressive 50-basis point hike in May, especially if March’s CPI inflation (due on April 12) prints well above 8% y-o-y,” he adds.
Liew has also projected three more rate hikes of 25 basis points in 2023 before the Fed concludes its current rate hike cycle.
“[This is estimated to bring] the terminal FFTR to 2.50%-2.75% by 3Q2023 (from the previous terminal rate forecast) [of] 2.25-2.50% by early 2024,” he says.
On the outlook for QT, the UOB economist expects the Fed to “issue the addendum to the Policy Normalization Principles and Plans in the upcoming May 2022 FOMC, followed by the formal announcement of QT to be made in the June 2022 FOMC and to start in July 2022”.
“[This is a] much shorter time gap between quantitative easing (QE) taper and the first policy rate hike when compared to the 2017-2019 episode which was three years apart,” he says.
Other analysts say…
The hike at the FOMC meeting in March was more hawkish than expected by investors, as well as the market, say analysts at Amundi Asset Management, Jonathan Duensing, Timothy Rowe and Paresh Upadhyaya.
The way they see it, the short end of the US yield curve is “more appropriately priced now that the market has discounted a more aggressive tightening cycle”.
“The long end of the US yield curve will potentially be influenced by geopolitics, growth prospects and inflation expectations,” they add.
“Should US inflation expectations become unanchored, the Fed has expressed a willingness to adjust policy more aggressively. For risky assets, the Fed’s general affirmation of market expectations is supportive, as near-term policy uncertainty wanes.”
According to the team at DWS, the impact of higher US interest rates will be limited for US real estate and private infrastructure.
“In a potential stagflation scenario in Europe, core-RAB regulated infrastructure may outperform in the medium-term, but diversification across core plus and value-added strategies would arguably still be preferable from a long-term investment perspective,” the team writes.
“Similarly, in US real estate, higher short-term rates will not necessarily drive longer-term rates higher. To the extent that longer-term rates are rising, it is largely due to rising inflation, which is positive for real estate. Real (inflation-adjusted) interest rates are still deeply negative. Real estate yields continue to offer an attractive spread against real rates on inflation protected government bonds,” they add.
Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International is keeping his expectations of a rate hike of three or four times this year, following Powell’s intention of bringing back price stability at the meeting.
“But the ensuing tightening conditions from a very hawkish Fed will damage growth,” he says.
“All in all, given our stagflationary baseline which got exacerbated by the Russia/Ukraine war, it appears that the Fed’s focus will weigh more on inflation fighting despite the uncertainty created by the situation in Ukraine based on the meeting [on March 15],” he adds.
“This creates further headwinds for asset markets as the central bank put remains further out of money in this cycle. From an asset allocation perspective, we remain cautious on both equities and credit,” he continues.
Allison Boxer, an economist at PIMCO says she expects the Fed to focus on the higher inflation as well as concerns on inflation expectations, compared to downside risks to growth in the next few months.
“As a result, our baseline forecast remains that there will be rate hikes at consecutive Fed meetings and a meaningful further tightening of policy throughout the year. This faster pace of tightening raises the risk of a hard landing further down the road and suggests a higher risk of a recession over the next two years,” she writes.
