Macro Insights Weekly: Implications of ratcheting rate hike expectations

Commentary: Implications of ratcheting rate hike expectations

There has been a dramatic shift in Fed signals and market expectations in the past week. Soon after raising the Fed Funds rate by 25 basis points in mid-March, Fed officials, most notably Chair Powell, began signaling that a robust rate hike cycle was in the making. The tone was dramatically more hawkish than what was conveyed in the March 16 meeting, and the markets took notice. During the course of last week, near-term rate hike expectations jumped and the yield curve (especially the 2yr-10yr segment) flattened in a pronounced manner.

For a central bank that has been very friendly to the markets and corporate sector in recent decades, why such a rapid escalation by the Fed? First off, the economy is in good shape, as seen in the latest sales and jobs data. The pandemic has largely ebbed, normalisation of activities is in full swing, jobs keep chasing potential employees, wages are rising, housing market is strong, and private sector balance sheets are sound by historical standards. Policy normalisation is overdue, clearly.

The inflation picture, meanwhile, is worrisome, at least for the time being. Headline inflation at 8%, with core at 5%+, is uncomfortable, with a wide range of prices, including food, rent, energy, and cars up sharply, and costs rising for an even wider range of production processes. With all the prevailing and pipeline pressures in place, we think that inflation will take time to stabilise. We now expect core PCE inflation to average 5% this year, and ease to a tad below 3% in 2023.

With this background, we now see two 50bps Fed rate hikes in store in Q2. Furthermore, we believe that rate hikes will continue until near-term rates exceed projected inflation rates. This would imply a terminal Fed funds rate of 3.5% by mid-2023.

Expeditious policy normalisation could lead to slower growth even as inflation remains high. The health of the US economy may be sound enough to give the Fed confidence to go ahead with policy tightening, but that doesn’t mean a combination of high inflation and rate hikes will be costless. We think the fast pace of rates adjustment will have some impact on retail sales, housing, and investment. Accordingly, we have revised down our forecast for US real GDP to 3% this year (a 50bps downward revision from our previous forecast), followed by a slower 2% in 2023. The risk to this forecast is that rate hikes hurt the housing market substantially, taking down with it home renovation spending and imparting a negative wealth effect. Then the growth outcome could be more disappointing than our forecast, which in turn could slow Fed rate adjustments.

As rate hike expectations have been priced in, the yield curve has flattened sharply in recent days. While such developments tend to signal growth slowdown or recession, we think it is too early to worry about such an eventuality, especially considering the underlying momentum in the US economy.

What about asset prices? If the US sells off, Asia ought to be in favour. Also, short-duration fixed income securities, along with growth to value rotation in equities would likely continue.