Market expectations are firmly behind a fourth consecutive interest rate hike of 75 bps by the Federal Reserve next week. The key story is whether the Fed opens the door at a slower pace thereafter, or the hawks’ focus on boosting core inflation signals a fifth 75bp move in December.
Markets on board for another 75bp hike
A fourth consecutive rate hike of 75 bps by the Federal Reserve looks like a given for next week’s Federal Open Market Committee (FOMC) meeting. After all, core inflation readings are pointing up rather than down, the economy has returned to growth after two consecutive quarters of falling GDP, while job creation continues apace with job vacancies rising they exceed the number of unemployed Americans by four million. The Fed continues to believe that inflation risks are “weighted to the upside,” that ongoing rate hikes are “appropriate,” and that a “sustained period of below-trend growth” is required to control inflation. As expected, the financial markets are fully priced at 75 bps.
Possible scenarios and market implications
A small minority of analysts are predicting a 50bp rise, a view that gained some traction following recent comments from a couple of doves on committee about the perceived risks of tightening policy too far and creating an unnecessarily deep recession. However, the general view is that this is more of a story about the size of rate hikes at subsequent meetings. Still, it certainly doused any talk of a 100bp rate hike. No analyst is forecasting such an outcome based on consensus poll responses, unlike recent meetings.
The current rate hike cycle vs. previous cycles – the orange circle marks where we are currently
The Fed could hint at a slower path ahead
The market had been favoring a fifth consecutive 75bp hike at the December FOMC meeting through the end of last week. However, a Wall Street Journal Last Friday’s article by Nick Timiraos, who has earned a reputation as the Fed’s go-to person when “senior managers” want to guide the market more directly, helped to upset the balance of thinking. His article hinted that some officials are worried that things were moving too fast and need to slow down the market a bit, which has reopened the possibility of “only” a 50bp hike in December.
This was followed by comments from San Francisco Fed President Mary Daly echoing Fed Governor Chris Waller’s sentiments that the Fed is “thinking a step down”. [in the pace of hikes]but we’re not quite there yet.” Smaller rate hikes from Canada and Australia have added to the sense that bankers are looking to tone down aggressiveness.
As Fed Chairman Jerome Powell has repeatedly admitted, monetary policy works on “long and varied lags” and having raised rates 375 bps, it may soon be time to stop hitting the economy so hard. aggressive. The speed with which Treasury yields, mortgage rates and other borrowing costs have been rising in the economy is causing some economic stress, particularly in the housing market, but there are also concerns that financial stress could be emerging in the system. Consequently, we expect the Fed to open the door at a slower pace through a formal forward guidance, but it may not necessarily do so.
Inflation needs to ease to avoid a fifth hike of 75 bps
With inflation not behaving as the Fed would like, the central bank will be reluctant to slow the rate of hikes until there is evidence that price pressures are moderating. The core CPI and PCE deflator continue to show prices rising 0.5% or 0.6% m/m, but for inflation to move towards the 2% y/y target we need to see monthly price changes of closer to 0, two%. So while recent commentary has offered some support for our current house view of a 50bp rate hike in December, the data has yet to do so.
As such, we have to keep the option open for a 75bp hike in December, even if the Fed’s language is a bit softer next week. Indeed, the stickiness of inflation also suggests that the risk is that our call for December to peak (at 4.25-4.5%) may be too soon, and it could be that we get a 50bp finish in February which would then mark ceiling. . This would leave a terminal rate of 4.75-5%.
The 10-year effect, market liquidity, and the Fed’s cost management
The market discount to the terminal fed funds rate is very important to the path of the 10-year Treasury yield. In the last week, that market discount went from 5% to 4.8%. And if the Fed raises 75 bps on November 2, the effective funds rate will rise to 3.83%. That’s still about 100 bps below where the market expects the effective funds rate to hit. The problem for the 10 years is if those 100 bp are delivered. And if not, either above or below the discounted 100bp. That’s where the direction for the 10-year yield will come from.
The other issue that will be interesting for the Federal Reserve is if it decides to talk about technical aspects of the market. There is $2.2 trillion in current dollars returning to the Fed on the reverse repo line overnight, reflecting continued excess liquidity in the system. Such is the size of that excess that the SOFR rate, effectively the general guarantee rate, has been dragged into the 3% area at times. It has even been below 3%, which is not very good since the fed funds floor is 3%. The rate the Fed pays in the reverse repo window is 3.05%.
Until now, the Fed has seen this through the prism of a facility that continues to do its job. That’s fair up to a point. But during the deepest moments of reflection, there must be a lingering feeling at the Fed that this is not an ideal set of circumstances, and one means of correcting this is through faster balance sheet liquidation. Alternatively, the balance sheet outflow will ultimately accumulate to a point where it begins to materially impact excess liquidity. But that will take some time; probably another few quarters.
One last point the Fed may or may not have an opinion on is its profit and loss account. Two questions here. First, the performance of your bond portfolio. Clearly, it has experienced a large capital loss so far this year, as has virtually every bond portfolio. Further increases in yields add to this negative performance. Second, it will be interesting to see if the Fed addresses the increase in the price to be paid for excess reserves, which is currently offset at a rate of 3.15%, and is likely to rise 75bps in line with other rates. There has been minimal comment on this from the Fed to date, but it is certainly something that could be commented on, in line with discussions of levels elsewhere.
Forex markets: hypersensitive to the pivot
The dollar enters the October FOMC 3-4% below its highs for the year. The move has coincided with the push towards the idea that the Fed may want to slow the rate of hikes, similar to what we have seen in Australia and, more recently, Canada.
The big question for the market is whether Powell wants to use the press conference to discuss the slowdown in the tightening cycle. Frankly, that’s very uncertain and that’s why we used the scenario approach above.
The arguments in favor of the dollar remaining relatively supported are: i) the market already values the pivot at a 50 bps hike in December and ii) the Fed knows how sensitive the rate markets are to communication, where the Bank European Central says it had made “important progress in withdrawing monetary accommodation” caused 30 bps to be erased from the ECB’s cycle price. Does the Fed really want to send that message?
As long as further gains occur, which seems likely unless month-on-month core inflation starts to fall sharply, we would expect the dollar to meet strong demand at any weakness. After all, the Fed is still struggling with core inflation moving away from its year-end targets. And as US real interest rates rise again later in the year, we would support a return to the highs for the dollar.
In terms of levels, we doubt EUR/USD will sustain gains above the 1.01/1.02 area and would favor 0.95, perhaps lower by the end of this year. The massive FX intervention by the Bank of Japan should not hinder USD/JPY’s return to 150. And USD/CNY should push towards the 7.40 area despite sporadic attempts by policy makers to stem the move.
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Publisher’s note: The bullet points in this article were chosen by the editors of Seeking Alpha.