The Federal Reserve (Fed) met expectations by raising policy rates by 50bp to a range of 0.75% to 1% and also provided a timeline for quantitative tightening.
The Fed is fixated on bringing down inflation, and the extent of its hiking cycle may even be priced in, meaning much of the spike in rates would be behind us. As such, it might be a good time to consider entry points in certain areas of fixed income.
Quantitative tightening will start next month
The Fed announced that quantitative tightening (QT) will start in June. For the first three months, the Fed will allow up to $30bn of Treasuries and $17.5bn of mortgage-backed securities (MBS) to roll off its balance sheet as securities mature.
From September, these amounts will double to $60bn and $35bn per month respectively (or a $95bn overall). Powell mentioned that its MBS holdings will likely roll off at a slower rate in practice, given the schedule of MBS maturities. This is a further indication that the Fed is unlikely to take an additional step of proactively selling assets to reduce its balance sheet, at least not over the next 12 months in our view.
We expect QT to take several years. We see a more neutral level of the Fed’s balance sheet at ~$3trn lower than today – at $6trn (~20% of GDP) by early 2025 (Figure 1).
Figure 1: We expect the Fed’s balance sheet to fall by $3trn by 20251
We now have a fully inflation-focused Fed
The Fed promised to be “highly attentive” to inflation and Chair Jay Powell said inflation is “much too high” and it is “essential” to bring it down. Powell left open the possibility of further 50bp hikes in June and possibly July while downplaying the prospect of a 75bp hike. For the first time in years, its growth mandate and sensitivity to markets are taking a backseat.
With CPI currently at 8.5%, many have been concerned about the Fed being well “behind the curve”. We can visualize this using the famous “Taylor Rule”, which estimates optimal policy rates. Using a version that uses unemployment and core inflation as inputs, the recommended policy rate is nearly 6%, and was well higher than the Fed’s policy rate for much of 2021.
However, we now project that this “policy gap” will narrow over the next two years, with both measures stabilizing at ~3-3.5% (Figure 2).
Figure 2: The Fed may have fallen behind the curve, but may catch up by next year2
External factors will also help the Fed moderate inflation
From our perspective in the Fed’s fight on inflation, the cavalry is coming. As we reach late Spring, so-called “base effects” will help moderate inflation in our view, given the strength of price rises last summer and late 2021.
Further, used car prices are reversing and fiscal policy is tightening with pandemic-era stimulus drying up. The sharp appreciation of the US dollar will also help reduce import prices. Legal immigration is also rebounding, having come to a stop during the height of lockdowns, increasing the labor supply with the potential to help slow wage growth.
On the negative side, Russia’s ongoing war in Ukraine will continue to disrupt commodity markets while China’s COVID-19 lockdowns are re-clogging global supply chains. On balance, though, we expect inflation will start to slow.
Will the Fed’s policy cause a recession next year?
The debate around the possibility of a US and global recession in 2023 has been heating up in recent weeks. The case for a recession hinges on the argument that persistent inflation will force the Fed to raise rates enough to cause a recession to control it (similar to former Fed Chair’s Paul Volker’s fight against 1970s’ stagflation).
However, not only do we expect inflation to slow, we also believe that the US economy remains in a good place fundamentally. There are more job openings than unemployed workers; 3% of workers could lose their job and still find another (Figure 3). Powell even described labor demand as excessive, indicating it would be healthy for it to fall somewhat.
Figure 3: The labor market is hot, with more job openings that unemployed workers to fill them3
Interest rate sensitive sectors may be more robust through this hiking cycle
The housing market has been a notable area of concern for those worried about rising rates. However, there remains an increasing shortfall of housing, given the collapse in the market after the 2008 crisis as residential investment revert to long-term averages (Figure 4). We believe we are nearly twice as underbuilt today as we were overbuilt at the peak of the housing bubble. As such, we believe sectors like housing construction will be relatively resilient to higher rates.
Figure 4: The US housing market shortfall is deepening, which will potentially support prices4
The Fed’s hiking cycle may be fully priced in
The market is currently pricing in three more 50bp hikes and an eventual terminal rate of ~3.5%. As such, we believe that the hiking cycle is largely priced in. If anything, the risks may now be skewed to Fed hiking less than expected.
If this is the case, the rise in Treasury yields may now largely be in the rear-view mirror. Further, it implies the Fed has a genuinely good chance of engineering the prized “soft landing.” However, even if we avoid a recession, it is likely to be a turbulent ride for financial assets along the way. Investors need to take care. We believe that certain areas of credit still look particularly attractive for this stage of the cycle, and this could be a good time to consider entry points.