USD Rates: Hike till something breaks
Overnight, the US Federal Reserve’s Open Market Committee increased the Fed funds rate (upper bound) by 75bps to 3.25%. This is clearly in restrictive territory (given that the long-run neutral is still kept at 2.5%). The dotplot and messaging are also unambiguously hawkish, putting a terminal rate of 4.75% (ahead of market pricing and our expectations of 4.50%). There is considerably more pain seen in the latest Summary of Economic Projections (SEP) compared to June. The Fed now expects an unemployment rate of 4.4% and GDP growth of 1.2% in 2023, compared to 3.9% and 1.7% respectively in June’s SEP. We now expect a Fed funds rate terminal of 5% to be hit in early 2023 (see writeup above).
The Fed has chosen via the dotplot to hike till something breaks. From a strategy perspective, this single minded pursuit of inflation points to an extension of the very challenging backdrop facing risk assets. Implied real rates of close to 2% in the short end have not been seen in a sustained fashion since pre-GFC. While it can be argued that the US economy might still be reslilient to the tightening, we are not as convinced. Recession fears are likely to feature more often as real rates rise. Inversion in the 2Y/10Y segment of the curve would probably go deeper. Levels could well approach that seen in the early 80s (-80bps seems plausible as a floor) when the US was in the last innings of the stagflation cycle. Previously, fading rate cuts in 2023 might make sense. Now, this has become a lot more tactical. If the Fed funds rates continue to rise expediously, speculation of rate cuts in end-2023 would intensify. The hawkish Fed, no adjustment higher in long-run neutral rate estimate and no discussion on MBS selling triggered a frantic curve flattening. At current levels, we think 10Y/30Y and 5Y/30Y do look interesting (a tad too flat). But if the environment is closer to early 80s, there might be better levels to be found before establishing steepening plays. Timing wise, it might not be till November till the Fed has a chance to revisit this issue.
There are broadly two factors that could prompt a Fed downshift. Economically, the Fed would be more comfortable if inflation (especially core CPI) cools a lot more and / or the labour market weakens materially. None of that has taken place with CPI sticky downwards and NFP still firm. Markets wise, financial conditions are not severe enough to prompt a Fed pivot. However, if credit spreads blow out and / or stock markets decline another 15-20%, the odds of hardlanding would rise materially and force a reassessment of the Fed path.
Lastly, there will be spillover unto EM/Asia rates. While Asia rates have had a considerable real and nominal interest rates buffer at the start of the year, this advantage has been eroded. With the Fed hawkish and the USD firm, there might well be a need for Asia central banks to step up their pace of hikes. 25bps at a go might not be sufficient with Jumbos likely in play. Speculation would likely intensify for laggards in this tightening cycle (Indonesia, Thailand) or those where currencies are facing considerable pressures (such as Korea). Our USD, SGD and HKD rates forecasts have been tweaked. (See table below).
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