The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Following four consecutive 75 basis-points (bps) increases to its policy rate, the Federal Open Market Committee (FOMC) finally slowed the pace of its rate-raising campaign, with a 50 bps hike at its December meeting — a move that had been widely anticipated by most observers.
Despite the smaller rate increase, the FOMC signaled that monetary policy might need to be even more restrictive in 2023 than it had projected this past September, with its policy rate likely going higher than what’s recently been reflected in market prices. Although the November inflation print showed further deceleration, US Federal Reserve (Fed) Chair Jerome Powell suggested that the FOMC will need to see “substantially” more evidence that inflation is continuing to drift lower — which could take several months or more of encouraging data — before the Fed would be willing to pause its rate-hiking cycle.
The annual US headline inflation rate, as measured by the Consumer Price Index (CPI), moderated to 7.1% year over year in November 2022 — its lowest level of the year — helped by a sharp decline in the energy components of the index. Core inflation also fell more than expected, to 6.0% year over year.
A significant drop in core goods prices accounted for the bulk of the easing inflation, while core services prices have proven “stickier” due to the shelter component remaining quite elevated relative to history. However, most of the leading indicators I track suggest that house prices will come down over the next six to 12 months. Even so, my base case right now is for US inflation to end 2023 above the Fed’s target, which would make it exceedingly difficult for the Fed to justify the interest-rate cuts the market has been pricing in.
I suspect the Fed will lift its policy rate to a terminal level of around 5% by the first quarter of 2023 and then go “on hold” to ensure that monetary policy remains restrictive enough to keep pushing inflation lower.
Thus far, the labor market has been quite resilient in the face of Fed policy tightening, but that will need to change before the Fed can even consider cutting rates. Unfortunately, that probably means the US unemployment rate will need to rise by more than the Fed is currently forecasting in order to achieve enough demand destruction to bring inflation down sufficiently.
As of this writing, I maintain a bias for the US Treasury yield curve to continue to flatten from here. Most fixed income investors are well aware of the heightened risk of an economic recession next year, with many proclaiming it would be the most well-telegraphed US recession of all time. If the Fed prematurely waves the “all-clear” flag and begins to cut rates with inflation still perched above its target, inflation could quickly reaccelerate, damaging the Fed’s inflation-fighting credibility in the process.
Bottom line: I’d say the Fed has a tough and unenviable task ahead of it.
Expert
After the US downgrade: Thoughts on public debt, bond yields, and Fed policy
Continue readingURL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Fed not yet willing to declare victory on inflation
We think the Fed is done raising rates for this cycle, despite the likelihood that they are being overly optimistic about inflation. Read to find out why.
Three themes (and what they mean) for income investors
With several macro crosscurrents at play, Portfolio Manager Peter Wilke suggests that income-oriented investors not lose sight of the “big picture” in their quest for yield.
US regional banking sector update
We explore how banking regulation and legislation could impact US regional banks, including highlighting the potential for M&A activity and for dispersion to drive long/short opportunities.
Financials amid rising dispersion
We explore why we believe dispersion across stocks, sectors, and geographies is supporting numerous secular themes in long/short investing in financials.
After the US downgrade: Thoughts on public debt, bond yields, and Fed policy
In the wake of the US debt downgrade by Fitch, Macro Strategist Juhi Dhawan explains what worries her most about the nation's debt situation and considers the impact on the term premium and the Fed’s plans.
Why cash won’t cut it for long: The case for bonds
Global Investment and Multi-Asset Strategist Nanette Abuhoff Jacobson and Investment Strategy Analyst Patrick Wattiau explore the relative potential benefits of bonds versus cash.
How to interpret the Bank of Japan’s latest policy shift
We analyse the wide-ranging investment implications of the Bank of Japan's latest policy shift.
Chair Powell maintains optionality
Fixed Income Analyst Caroline Casavant shares what she thinks matters most for investors in light of the latest interest-rate hike from the Fed.
Fed skips along the path to a pause
Jeremy Forster analyzes the Federal Reserve's decision to pause its interest-rate hiking cycle, explains why he believes it could be an extended pause, and shares the potential implications for fixed income markets.
Europe/US divergence: the ECB has further to go
How far will Europe diverge from the US? Macro Strategist Eoin O’Callaghan sees several reasons sustaining this growing divergence.
When the US sneezes, does the world still catch a cold?
Macro Strategist John Butler discusses the growing potential for cyclical and monetary policy divergence, despite markets pricing for the contrary, and assesses what it means for investors.
URL References
Related Insights