Powell, September 2022
''The hiking path we execute will be enough. It will be enough to restore price stability.''
Draghi, July 2012
''The ECB is ready to do whatever it takes to preserve the EUR. And believe me, it will be enough.''
Fed decision
Fed hiked interest rates by 75bps setting its target range to 3–3.25%, in a unanimous decision and maintained guidance that ongoing increases will be appropriate. Fed said it would be prepared to adjust the stance of monetary policy as appropriate, while it noted that inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.
While the decision was in line with the market consensus, the “dot plot” of the future rate path was somewhat more aggressive than expected, suggesting the Fed will hike by at least another 100bps – and more likely 125bps – by year-end. Fed Dot Plots saw the terminal rate, 2023 median rate forecast hiked to 4.6% from 3.8% which is towards the top end of analyst estimates and above money market pricing beforehand of 4.5%, while the 2022 dot plot was also more aggressive at 4.4% (prev. 3.4%). Furthermore, the Dot Plots implied rate cuts to 3.9% and 2.9% in 2024 and 2025, respectively, while the long-run (neutral) dot was left unchanged at 2.5%.
Goldman Sachs raised its forecast for the Fed's pace of interest rate increases after Powell's hawkish signal. It now expects rate hikes of 75 bps in November, 50 bps in December and 25 bps in February for a peak funds rate of 4.50%-4.75%, compared with 4.00%-4.25% before. The path for the funds rate in 2023 will depend on how quickly growth, hiring and inflation slow.
While UBS view is that a federal funds rate of 4% is about the highest that the economy would be able to withstand, with the Fed clearly threatening to raise rates above that level. On their forecasts, inflation may be low enough for the Fed to pause the rate hiking cycle after the December meeting. However, UBS believes that if inflation does not come down as quickly as they expect and the Fed raises rates closer to 5%, it will be difficult to avoid a recession.
In the post-meeting press conference, Chair Jerome Powell's remarks were clear. He kicked off his presser in a similar vein to his Jackson Hole speech, affirming the Fed's affinity to bring down inflation to target, adding that the Fed will bring rates further into restrictive territory. He repeated over and over that the Fed is focused on achieving price stability. The central bank expects that this will require a sustained period of restrictive monetary policy, sub-trend economic growth, and higher unemployment. Powell said the Fed has now moved to the "very lowest" level of what the Fed considers restrictive, saying there is still a way to go on rates, without giving specifics on where he sees the terminal aside from his comment that the Fed would likely get to levels in the Dot Plot.
Market reaction – Fixed Income
The Treasury curve saw pronounced flattening whilst the long-end made session peaks after the FOMC. The more hawkish than expected Fed inverted the US yield curve further, as the 2-10 inversion fell well below -50 bps and therefore to its most inverted level since the early 1980’s as the market figures that the Fed’s continue pace of rate tightening will eventually lead to a recession.
The US 2-year yield broke the 4% for first time since 2007 and was up 10 consecutive sessions. We haven't had a longer stretch (11 days) since April 2018. There hasn't been a 12-day run since 1988.
Macro Alf noted: Real yields are basically unchanged, but the entire real yield curve today (orange) trades well above 0% - tighter conditions for longer.
Higher real yields are not necessarily a headwind for risk assets, but they become one if real growth is slowing down too - exactly what's happening now. The more the Fed tightens, the more long-lasting damage it will do to future growth: the slope of the yield curve dramatically flattened.
Market reaction – Equity
Stocks were ultimately sold – SPX fell beneath 3800 – with indices extending to lows in late trade after Powell's presser/Q&A finished.
After the Fed rate decision and press conference, equity markets gyrated between gains and losses, but ultimately the S&P 500 finished 1.7% lower on the day and 2.5% lower than where it was right before the announcement. While the rate hike of 0.75% was expected, stocks were likely mostly reacting to the Fed’s slightly more hawkish projections for the funds rate.
Market reactions to Fed policy decisions have been quite volatile this year, and, over subsequent days, markets have often reversed their initial knee-jerk response. Still, we don’t see any change in the Fed behaviour. The Fed remains squarely focused on getting inflation down to more acceptable levels and believes this could require a fairly lengthy period of relatively high interest rates. This means corporate profit growth will continue to decelerate, and there is a material risk that profits will decline at some point in 2023.
Did geopolitical risk also contribute to market volatility?
Aside from the Fed, geopolitical uncertainty also weighed on investor sentiment today, with Russia taking steps that represent an escalation in the war against Ukraine. President Vladimir Putin announced a “partial mobilization” of 300,000 reservists on Thursday and renewed his warnings of a nuclear threat.
A cease-fire in Ukraine remains elusive, in our view, and the conflict continues to be a source of potential volatility for markets, as well as a drag on global growth. The conflict has focused the attention of governments and companies on safety and security, over pure considerations of price and efficiency.
What is the impact of interest rate rises?
Higher interest rates —> Increases interest payments —> Increases the cost of the capital —> Decreases demand for consumer and corporate borrowing —> Higher default rates / Decreases demand for real estate —> Increases the discount rate for equities / Lower company earnings —> Reduces disposable income and thus consumption (70% of GDP) —> Increased incentive to saving vs spending —> Higher unemployment —> Lower growth
What's next?
The market implied pricing for the terminal rate (peak interest rates) is now at ~4.5%, much higher than where we are now but with core inflationary components such as shelter and food accelerating, we could be due an upside surprise which means more rate hikes than expected. Every time the Fed has embarked on an interest rate tightening cycle, it has ended in a market crash or crisis.
The real risk we will face by the 2022 winter and beyond is the credit market's illiquidity because of the huge rise in spreads coming. The next phase could be an upturn in corporate defaults from 2.8% in 2022 (expected) to a 5-6% range next year for the US High Yield markets.
With continued below-trend growth alongside a higher probability of potential recession over the next 12 months, we continue to prefer the up-in-quality allocation. Alongside our up-in-quality preference, we continue to like short-end investment grade bonds. We are positioned for additional curve inversion as an economic boom/bust scenario unfolds and we recommend to stay away from bonds below Investment Grade ratings in 2023/2024, unless you have a perfect knowledge of the balance sheet of the issuer.