The Federal Reserve has delivered a widely telegraphed 50 bps rate hike this week and signaled at least two more 50 bps increments in June and July as part of the anticipated front-loaded trajectory of rate increases. The market had been pricing in even a 75 bps increment in the coming months and may do so yet again if inflation edges higher still. These developments are all part of the FOMC’s aggressive tightening sequence that could see the Fed Funds rate approach 2.75% by year-end. The Fed also announced the commencement of its quantitative tightening (QT) efforts starting June 1 which would aim to reduce the Fed’s balance sheet which presently stands at nearly $9 trillion.
We have written extensively in recent weeks about the broad-based surge in price pressures in the US economy, and Fed Chairman Powell confirmed at his Wednesday press conference this week how this remains a major challenge. Latest March data showed headline and core inflation at 8.5% and 6.5% respectively, the highest in four decades, amid the spike in energy and food costs, strong consumer demand and supply disruptions. Unfortunately, key inflation drivers are showing no signs of abating soon and Mr. Powell admitted the Fed’s toolkit can only address the demand side.
Indeed, supply-side bottlenecks have been exacerbated in recent weeks by war and the pandemic – the Ukraine conflict and lockdowns in China’s major cities continue to negatively impact global trade and already challenged supply chains, while pushing energy and food prices higher. Mr. Powell’s mention of Russia and China as exogenous supply-side factors impacting price pressures implicitly recognizes that there may yet be more inflation pain especially via food and energy prices with no remedy that the Fed can offer.
In the meantime, two data points favored by the Fed are signposting further cause for concern. First, the Employment Cost Index rose by 4.5% y/y during 2022 Q1, the fastest increase on record, which suggests wage increases have helped fuel consumer spending and could result in a wage-price spiral. Second the Fed’s favored inflation gauge, the personal-consumption expenditures (PCE) price index was up 6.6% in March, the highest since 1982. In sum, it seems highly improbable that core inflation could fall to 2% anytime soon, and getting it down toward even 3% appears to be an uphill battle.
At the same time however, there are mounting concerns that economic growth may not hold up, especially if the Fed raises rates rapidly. Already, there are rising headwinds given that US GDP actually contracted in 2022 Q1, a major surprise that defied consensus expectations of modest growth. Net exports detracted from economic growth as the US trade deficit widened to a record high. A stronger dollar and supply-side dynamics have boosted US imports while slowing global growth has weighed on US exports. There are concerns that wage increases will not keep up with elevated inflation, thus further eroding already weaker purchasing power – this, combined with lower disposable incomes amid higher food and energy costs, and the negative wealth effect of the markets sell-off in recent months, might reduce consumer spending.
Against this backdrop, uncertainty prevails as there are a lot of unanswered questions. For example, how much more will the Fed have to raise rates to tame inflation, and would a fast and furious tightening cycle derail growth? What is a neutral level for interest rates? If rates reach “neutral” somewhere around 2.5%, and inflation is still rampant, what then? What are recession risks?
US Treasury yields have unsurprisingly risen rapidly, with the 10-year tenor having breached 3% in recent days. Thus, market expectations have also helped tighten financial conditions. Apart from US economic data releases, foreign appetite for US paper will also impact UST yields. As it turns out, currency market gyrations have also complicated matters. Market expectations of higher US rates have underpinned the greenback, as a result of which most other currencies have been on the back-foot. In particular, the Japanese yen (JPY) and more recently, the Chinese yuan (CNY), have borne the brunt of the US dollar’s ascendancy. Both JPY and CNY have weakened to multi-year lows – the former due to the major policy divergence between the Fed and the BOJ, and the latter due to a sharp Chinese economic slowdown and capital outflows as Chinese markets sell-off. These FX market changes have raised hedging costs for Japanese investors and lessened the appeal of holding USTs on a hedged basis. If the rapid CNY decline continues apace, Chinese policymakers may have to pare their UST reserve holdings to support the local currency. Therefore, volatility in US rates is likely to remain elevated amid heightened uncertainties.
In sum, even as the Fed is finally on its way to playing catch-up with double-barreled monetary tightening efforts that include aggressive rate hikes in tandem with balance-sheet contraction, there is a central element of data dependency for policymakers as they look to manage a growing number of variables. Volatility is here to stay as liquidity is drained by a hawkish central bank. There are numerous questions vexing investors, that remain unanswered for now as only time will tell. In such an investment environment, taking directional bets is foolhardy, and investors are best off availing themselves of the expanded opportunity set of mis-pricings and valuation overshoots via seasoned relative value managers.