Macro Insights Weekly: Jumbo rate hikes and the road ahead
- We expect three more 50bps and one 25bps hikes this year
- The impact of higher rates and tighter liquidity is unambiguously challenging for asset markets
- There may be a desire to trade peak inflation and rates, but hazy outlook warrants caution
- Rate hike cycles come with the risk of major asset market dislocations
- This cycle, which just turned more accentuated, will be no different
The US Federal Reserve’s Open Market Committee (FOMC) hiked the Fed Funds rate by an unusually large clip of 75bps at the end of its June 14-15 meeting. This move was telegraphed earlier through a highly unusual newspaper leak, thus the market was not caught off-guard. Yet, the action and the guidance provided in the FOMC statement, committee members’ forecasts, and Chair Powell’s press conference marked a major step-up in the battle against inflation. Concerns about inflation are acute, while the concern on the economy is still relatively muted, owing to overall consumer spending remaining strong. On the latter, despite signs of some loss of momentum, it is striking that May retail sales were up by 30% over the same period three years ago. A slowdown is surely coming, but the data are yet to hint at the depth and duration of the loss of momentum ahead.
The Fed is going to go ahead with rate hikes and balance sheet adjustment, and given the June meeting’s outcome, their keenness to bring forward policy adjustments is clear. Taking that cue, we think that rate cycle runs its course this year, with three more 50bps and one 25bps hikes ahead. That would take the policy rate to 3.5% by the end of the year. Inflation will have well peaked by then, but the pace of disinflation or ensuing growth slowdown may not be sufficient for the Fed to cut rates in 2023, in our view. Still, growth will get dragged down by housing and investment, both highly interest rate sensitive, through the course of next year. That could tip the US economy into a recession in Q423 or a tad later, which in turn could make 2024 the year of rate cuts.
The labour market’s best days may be behind, with unemployment rate likely to rise modestly going forward. The same likely holds for wages. We accept that the risk of the terminal rate heading to 4% is not trivial, but we think that the nexus of inflation and growth outlook remains consistent with a 3.5% terminal rate.
The impact of higher rates and tighter liquidity is unambiguously challenging for asset markets. There may be a desire to trade peak inflation and rates, but uncertainty about the outlook is large enough to warrant caution. Energy inflation could continue to haunt the global economy through this year and next, while production and distribution challenges associated with a vast array of food and non-food commodities are likely to linger. The impact of this uncertainty will continue to weigh in on global capital markets and risk sentiments on the entire spectrum of assets. No rate hike cycle has come and gone without major asset market dislocations, credit events, and currency crises in the fragile parts of EM and DM. This cycle, which just turned more accentuated, will be no different.
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