9 Dec 2022
United states Federal Reserve preview: trapped between a rock and a hard identify
A 50bp hike is widely expected given high inflation and a tight jobs market, but the market is pricing in a recession, and falling Treasury yields and a weakening dollar are undermining the Fed’due south efforts to dampen price pressures. A hawkish Fed message will likely fall on deaf ears unless the data start proving the fundamental banking company right
In this article
- A stride downwards to a higher tiptop
- Signalling could autumn on deafened ears
- Aggrandizement makes things catchy
- 5% in the first quarter but rate cuts from the third
- Marketplace rates have dropped like a stone – time for the Fed to sell bonds?
- FX markets: Short-finish rates concord the key for the dollar
Expected Federal Reserve interest rate hike
A stride down to a higher peak
A 50bp hike at the 14 December Federal Open Marketplace Committee (FOMC) meeting is the strong telephone call from both financial markets and economists. Later on implementing 375bp of charge per unit hikes since March, including consecutive 75bp moves at the previous iv meetings, Federal Reserve officials are of the view that they’ve made “substantial progress” on tightening policy and then it is time to “step down” to lower increments. Nonetheless, Fed Chair Jerome Powell and the team have been at pains to point out that despite smaller individual steps, the “ultimate level of rates will demand to exist somewhat higher than idea at the time of the September coming together”.
Scenarios for the 14 Dec FOMC coming together
Signalling could fall on deaf ears
In this regard, the Fed will exist concerned past the recent steep falls in Treasury yields and the dollar, coupled with a narrowing of credit spreads, which are loosening financial conditions – the verbal opposite of what the Fed wants to see as information technology battles to go inflation lower.
These moves were themselves triggered by a weak core CPI print for October that came in at 0.3% month-on-calendar month versus a 0.v% consensus expectation, while the Fed’s favoured measure of inflation – the core personal consumer expenditure deflator – was even softer, rising just 0.ii%. The marketplace reaction seems excessive to us given this is just one month of data, almanac core inflation is notwithstanding running at triple the target, and to striking 2% yr-on-twelvemonth the month-on-calendar month readings demand to average 0.17% over time – and we aren’t there still. The Federal Reserve will need to come across several months of core inflation readings of 0.i% or 0.ii% to exist confident that aggrandizement is on its fashion back to target and this is likely to be a fundamental plank of its messaging.
With that in mind, we think the Fed is non finished with its rate hikes and its new forecasts will indeed indicate a higher path for the Fed funds rate to 5% with potential slight upward revisions to virtually-term Gdp, and persistently high aggrandizement forecasts used to justify this. Certainly, the consumer sector has been property up better than many – including ourselves – expected, with strong jobs and income gains supporting spending.
ING’due south expectation for what the Fed volition predict
Looking further alee, several officials such every bit James Bullard and John Williams have suggested the Fed may not be in a position to cut involvement rates until 2024, and we suspect Powell and the forecasts will echo this sentiment. However, we strongly doubtable that this is more than tied to the Fed trying to get longer-dated Treasury yields higher rather than a confidence telephone call that recession and lower inflation over the medium-term will be avoided.
Inflation makes things tricky
At present, it is important to remember we get November inflation on 13 December – the day before the FOMC meeting – and the outcome will exist of import for what the Fed has to say. If core CPI comes in at or above the 0.3%MoM consensus forecast, its messaging as outlined above will probably prevail. If aggrandizement is softer and yields tumble further then the Fed may have to be more than forceful and perhaps raise the possibility of accelerating a run-downward in the size of its balance sheet via reduced reinvestment of gain from maturing assets. The fundamental bank will stick with the hawkish messaging until it is confident aggrandizement is beaten.
5% in the first quarter but rate cuts from the third
In terms of our view, we look for a concluding 50bp hike in Feb, taking the Fed funds ceiling to five%. But like the market, we think a recession will dampen toll pressures and the composition of the US inflation handbasket, which is heavily weighted to shelter and vehicles, volition facilitate a far faster drop in annual inflation readings than elsewhere. Recall besides that the Fed has a dual mandate which includes an employment dynamic. This offers the Fed greater flexibility versus other central banks to answer with stimulus and we believe information technology will from the tertiary quarter of 2023 onwards.
Marketplace rates take dropped similar a stone – time for the Fed to sell bonds?
If the Fed wants to re-tighten fiscal atmospheric condition past plenty, it needs to engineer a hawkish hike. Longer dates, in the wake of the recent falls in yields, are trading equally if the Fed is done post the Dec hike. Assuming the Fed is not done, the first quarter of 2023 should sustain a ascension rates theme to it. That should force yields support, commencing a dis-inversion process on a curve that is at present heavily inverted. We’ve likely seen the peak in market rates, simply that does not preclude market rates from moving higher, at least for as long every bit the Fed is still hiking and the end-game is non fully clear.
The Fed has not said also much about the circumstances on the coin markets. We still take in excess of $2tr going dorsum to the Fed on the contrary repo facility, reflecting an excess of liquidity in the organisation. This in turn is driven at that place equally a counterpart to the volume of bonds still sitting on the Fed’southward balance sheet. The Fed is rolling off some $95tr per month, only there is ever the option to do more, or more pertinently to sell bonds back to the market place outright. While it may be a tad premature to suggest this, information technology’due south an option should the Fed really want to run into longer-dated market rates revert college.
FX markets: Short-end rates hold the cardinal for the dollar
Dollar toll activeness over the final two months has been very poor. The dollar has tended to sell off sharply on signs of softer cost information only has struggled to rally on any positives – such equally the November Us jobs reports. That toll activity suggests a market defenseless long dollars at higher levels subsequently a five-quarter dollar rally. The hope for dollar bulls now is that positioning is much better balanced after an eight% drop in the merchandise-weighted dollar and a 12% drop in USD/JPY.
Preventing an even sharper dollar sell-off has probably been the view that the Fed will proceed to hike into 2023. The final rate is still priced non far from 5% and only 50bp of rate cuts are priced in the second one-half of 2023. Equally long as the FOMC statement, Dot Plots, and press conference practise not generate any more dovish pricing – and that seems unlikely – we doubt the dollar has to sell off much further.
Our baseline view would see EUR/USD holding around the one.05 area equally the Fed validates the electric current pricing of its trajectory in money markets. A more dovish plow would exist a surprise and with seasonals against the dollar in December, EUR/USD could spike above resistance at one.06 towards the one.07 area in thin year-stop markets.
Our multi-week preference, however, is that the Fed is still going to talk tough, and heading into January the dollar starts to brand a comeback – where four.5%+ deposit rates look increasingly attractive amid a global slowdown.