Overview
What happened?
At today’s Federal Open Market Committee meeting, the Fed hiked Fed fund rates by another 75bp, thus delivering on the hints that hit the market a couple days ago via a Wall Street Journal article. In addition, the dot plots show a steep rise in forecast end-year Fed fund rates, implying an additional 175bp of hikes. The Fed still sees inflation coming down sharply in 2023 (though 2022 forecasts were raised sharply) while growth forecasts were revised sharply lower, indicating some acceptance of the hard landing risks associated with the current aggressive tightening. Lastly, the current pace of quantitative tightening was reaffirmed as $47.5bn reduction per month increasing to $95bn in September.
In his remarks, Fed chair Powell reiterated the commitment to bring inflation down and justified the 75bp hike by noting that both inflation and labour market prints remain inconsistent with the Fed’s goal. In addition, unlike last time, he kept the door open for another 75bp hike in July and reiterated the data dependency behind the size of the hikes. Although Powell didn’t rule out a series of 75bp hikes from here, he kept the flexibility intact to lower the magnitude of hikes in coming meetings.
Our interpretation
The Fed’s rising hawkishness implies that the central bank is now willing to take the pain of bringing inflation down, challenging our view that the Fed will deliver less than what the market is currently pricing. The 75bp hike, the aggressive recalibrating of policy, and the growth/inflation picture show that policy driven recession risks have risen sharply. Following the very strong CPI print, we increased the hard landing risk to 60 per cent from 35 per cent previously and expect the current phase of stagflation to evolve into a more serious growth slowdown than the Fed is expecting over the next six to 12 months.
Outlook
We continue to think that the ongoing aggressive tightening in financial conditions (which is significantly higher than 2013 and 2018 given higher inflation) will probably lead to a serious and sharp slowdown in growth in the coming months. We think a lot of the hawkishness the Fed is displaying right now is already priced in and sectors sensitive to interest rates, such as housing, are likely to feel the pressure in a sustained way. Moreover, we are already seeing signs of consumer weakness as the collapsing confidence we have been picking up through our trackers is turning into hard data (e.g. the latest retail sales print). Lastly, given the very high debt in the system, there is a limit to how much further real rates can move up, and we are already seeing debt financed balance sheet issues playing a big role in shaping European Central Bank policy, which is now likely to do hiking alongside some version of QE going forward in order to keep financial stability intact in the euro area.
Asset allocation views
Our S&MA’s core tactical asset allocation grid remains cautious with underweights in equities and credit. We also have an underweight in US vs other DM countries in fixed income. As we pass through this phase of strong hawkishness, we think this set-up of views makes sense. Already, we think that credit markets remain vulnerable here given the scope for a serious slowdown and recession that the current tightening could precipitate. However, we also think we are nearing the point where the damage to growth in the pipeline will start to dominate inflation as the primary concern for both policymakers and markets.
