United States
Markets may have had a tough start to the year, but the Federal Reserve (Fed) intensified its hawkish tone yesterday, guiding to policy rate "lift off" in March and quantitative tightening to follow. Market volatility would need to be more severe than in recent weeks for it to reconsider.
Fed playing catch-up again
The Fed has potentially lost control of the narrative in recent weeks, playing catch-up to market pricing and public sentiment on inflation.
Going into this meeting, speculation was rife that the Fed would hint at hikes in consecutive meetings, or even in 50bp increments – a far cry from the December meeting where just two members projected four hikes in 2022.
Chairman Powell left multiple hiking paths on the table, highlighting that the Fed will be “nimble”. Powell also emphasized the Fed will be transparent to avoid surprising the market, thus potentially making it easier to execute rate hikes.
We currently expect hikes in 25bp increments every other meeting
While the path of policy can change, our base case is that the Fed will hike rates in 25bp increments every other meeting. Even though Powell refused to rule anything out, we see sharp 50bp hikes to be unlikely, with the Fed preferring to leave the door open to increasing the pace of hikes if needed.
“Quantitative Tightening” is coming, but liquidity will remain abundant
In addition to its usual statement, the Fed released principles for reducing the size of its balance sheet, reaffirming that it plans to allow assets to run off its balance sheet after policy rate "lift off".
The principles state: “In the longer run, the Committee intends to hold primarily Treasury securities”, indicating that the Fed will roll-off its MBS holdings faster than its Treasury holdings.
Although Powell remained guarded as to potential timing, we expect the Fed to start this process in May or June and, as hinted at the press conference, proceed faster than last cycle’s pace (when the Fed started reducing its balance sheet by up to $10bn per month, gradually ramping up to $50bn per month).
However, given the sheer size of the balance sheet following pandemic-era purchases, even at a faster $80bn monthly pace from May (which we believe is a sensible base case), the balance sheet would remain larger as a share of GDP than its 2014 peak until late 2024 (Figure 1).
Figure 1: Quantitative tightening has room to be more aggressive than in the past1
As such, we are still years away from a “normal” balance sheet, indicating that liquidity will be abundant by historical standards for some time yet, before potentially impacting risk markets.
The Fed is looking through risk market volatility
Although equity markets had a tough start to the year, the Fed clearly did not see this as a reason to moderate its tone.
This also makes sense to us. Financial conditions were significantly tighter in Q1 2016, Q1 2019, and Q1 2020, when the Fed made a significant dovish policy shift. At current levels, we do not believe we are near the threshold for the Fed to turn dovish again (Figure 2).
Figure 2: Financial conditions were far looser when the Fed previous tilted dovish2
When questioned, Powell stated that financial market conditions are a concern to the extent that they impact the Fed’s employment and inflation mandates. So as such, there will always be a ‘Fed put’ at some level, as financial markets’ prices impact the wealth effect, cost of credit, and sentiment channels. However, the ‘strike price’ of this put is dynamic, and we believe present market values are meaningfully away from it.
We believe it will take more equity market weakness to make the Fed look past 7% inflation than it would 2.5% inflation (Figure 3).
Figure 3: "Sticky" CPI and employment trends are too much for the Fed to ignore3
Lift off for hawks
The Fed’s balancing act will be to attempt to slow inflation without harming the labor market (a so-called "soft landing").
The Fed will receive support in this effort, as fiscal stimulus declines in 2022, supply chains normalize, we believe they can succeed in slowing inflation while the amount of excess savings should support growth. However, we believe as growth moderates, it will potentially favor certain areas of credit over equity.
