No pivot in sight for the Fed as economic projections worsen
As expected, the Federal Open Market Committee (FOMC) hiked rates by 75 basis points yesterday. Less expected was the hawkish stance of its quarterly “dot plot,” which showed a policy prescription that is much higher than its June dot plot. In short, there was no Fed pivot.
Taking a step back, we are witnessing the normalization of monetary policy and the normalization of markets, which should be positive. However, it is the speed and size of the rate hikes that is creating disruption for major asset classes in the near term.
What does the FOMC expect to happen next?(1)
Current projections have changed significantly from the projections the FOMC released in June.
In the press conference, Fed Chair Jay Powell said the Fed is taking “forceful and rapid steps to moderate demand” and that “there is still a way to go.” Powell acknowledged that longer-term inflation expectations remain well anchored, but that he would like to keep it that way through this aggressive path.?
The Fed also announced that it will continue to follow its quantitative tightening plan, which means a substantial increase in the monthly amount of securities being rolled off the balance sheet.?
How did markets react?(2)
After the announcement, stocks fell, then rose, then fell again, with the S&P 500 finishing the day down 1.7%.
The 2-year/10-year US Treasury yield curve became increasingly inverted, with the spread widening to -53 basis points — illustrating the market’s increasing pessimism about near-term economic prospects. Meanwhile, the spread between the 3-month/10-year US Treasury spread remained positive at 22 basis points.?
Copper fell while gold rose modestly, reflecting dimming prospects for the economy as tightening continues aggressively.
What is our outlook on the situation?
The market’s immediate reaction was to be expected, given the hawkishness of the dot plot. If you were to compare this rate hike cycle to previous rate hike cycles going back to 1983, the Fed has never raised rates this much in this short a time period.(3) I believe it is becoming increasingly difficult for the US to avoid recession given the Fed’s “forceful and rapid” rate hikes.
More hawkish Fed rhetoric is likely going forward. And we are likely to see continued hawkishness from other major central banks such as the European Central Bank, the Bank of England and the Bank of Canada.
What is our resulting investment view?
In the shorter term, I believe risk assets are likely to underperform as the increased risk of recession is more fully discounted by markets. The Fed’s policy going forward will largely dictate how significant and long-lasting the US economic downturn will become, and therefore how soon stocks will begin to recover.
Dollar strength is likely to continue in the shorter term given the hawkishness of the dot plot.?
What are the risks to our view?
The downside risk to our view is that the Fed might start to believe inflation is more entrenched and that it needs to become more aggressive – essentially a continuation of the playbook we have seen this year where the Fed has followed a slippery slope of increasingly aggressive policy as its views on inflation (supported by data) have changed.
The upside risk to our view is that the Fed may prove to be less hawkish than markets now anticipate.
With contributions from Brian Levitt, Paul Jackson, David Chao, and Arnab Das
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1 Source: All data points in this section are from the FOMC’s Summary of Economic Projections as of 9/21/22
2 Source: All data points in this section are from Bloomberg, L.P., as of 9/21/22
3 Source: US Federal Reserve
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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Tightening is a monetary policy used by central banks to normalize balance sheets.
A basis point is one hundredth of a percentage point.
Personal consumption expenditures (PCE) measure price changes in consumer goods and services. Expenditures included in the index are actual US household expenditures.
The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.
The federal funds rate, or fed funds rate, is the rate at which banks lend balances to each other overnight.
The terminal rate is the anticipated level that the federal funds rate will reach before the Federal Reserve stops its tightening policy.
The Federal Open Market Committee (FOMC) is a committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
An inverted yield curve is when shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.
Risk assets are generally described as any financial security, such as equities and others, that carry risk and are likely to fluctuate in price.
Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.
Spread is the difference in yield between two different bonds.
The opinions referenced above are those of the author as of Sept. 21, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.?