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    Instant Insights: We have lift off

    Instant Insights: We have lift off

    March 17, 2022 Fixed income

    The Federal Reserve kicked-off its rate hiking cycle, with its first rate rise since 2018, and displayed a hawkish tone for the third straight meeting.

    Although inflation is a concern, we ultimately believe that the domestic economy and financial markets are currently well-placed to perform as the hiking cycle begins.

    The Fed left the economy to run “hotter” than usual

    This was the “hottest” the Fed allowed unemployment and inflation to run before enacting a “lift off” in rates (albeit its attitude toward inflation changed after the stagflation crisis in the 1970s) (Table 1).

    Table 1: The “hottest” economy before lift-off in history1

    Initial Hike Unemployment rate (%) CPI (% year-on-year)
    Apr-1956 4.0 0.7
    Aug-1958 7.4 2.1
    Feb-1961 6.9 1.4
    Nov-1967 3.9 2.7
    Apr-1971 5.9 4.2
    Jun-1975 8.8 9.4
    Aug-1980 7.7 12.9
    Mar-1983 10.3 3.6
    Jul-1985 7.4 3.6
    Apr-1988 5.4 3.9
    Feb-1994 6.6 2.5
    Mar-1997 5.2 2.8
    Jul-1999 4.3 2.1
    Jul-2004 5.5 3.0
    Dec-2015 5.0 0.7
    Mar-2022 3.9 7.9

    The current highs in inflation and lows in unemployment have raised concerns about the Fed being “behind the curve”, thus risking a hard landing into recession. However, the Fed appears to be keen to address those fears, as this was the third hawkish meeting in a row.

    Another hawkish meeting

    The Fed’s quarterly “dot plot” was increasingly hawkish for the third straight meeting. The median projection rose to seven rate hikes this year, up from four in December (Figure 1). This implies one 25bp hike at every remaining meeting this year. Seven members were even more hawkish than this, pointing to openness toward 50bp moves.

    Figure 1: The Fed's increasingly hawkish trajectory continues2

    15472-InstantInsight_Chart2_15-03-22_840x300px.jpg

    The policy trajectory remains uncertain, however. The interplay of geopolitics, inflation and growth are currently uncertain. As such, we believe investors need to treat these projections as tentative. Our own base case is for five hikes this year based on our views of growth and inflation.

    Although there are challenges, we expect the domestic economy to remain healthy through the hiking cycle

    The Fed’s quarterly projections show PCE ending the year up 4.3% from 2.6% previously and staying above target through 2024. As such, it downgraded its growth projection from 4% to 2.8% at the end of 2022.

    In our view, the domestic economy can withstand rate increases and grow at or above trend through 2023.

    However, with fiscal stimulus rolling off, the consumer’s ability to withstand inflation could be challenged. Disposable incomes have been falling given the end of pandemic-related fiscal support. We do not expect disposable incomes to recover until later in the year when wage growth will potentially be high enough to compensate for fiscal drag (Figure 2).

    Figure 2: Disposable incomes falling make it tougher for the consumer to absorb inflation pressure3

    15472-InstantInsight_Chart1_15-03-22_840x300px.jpg

    Although we are watching this dynamic closely, we believe that the large pool of excess consumer savings amassed over the pandemic, as well as historically low consumer leverage, will provide consumers with a buffer to keep economic growth healthy.

    We also expect low real rates to continue to support financial markets

    We currently project that the real Fed funds rate will be negative through 2023, which is good news in our view for financial assets.

    Figure 3: Real yields will potentially remain negative for some time yet4

    15472-InstantInsight_Chart3_15-03-22_840x300px.jpg

    In the previous cycle, the economy and markets proved resilient when the Fed tightened until real yields approached positive territory. This provides the Fed ample room to hike before markets become particularly concerned. Tightening policy is different than tight policy.

    Looking ahead, markets will also need to deal with quantitative tightening, which Chair Powell stated will likely commence “at a coming meeting”. We expect an announcement in May or June at a pace of $80bn per month. But, we are still years away from a “normal” balance sheet level.

    The end of the beginning of the expansion

    To paraphrase Winston Churchill, we believe this hike marks the “end of the beginning” of the current economic expansion rather than the “the beginning of the end”.

    The easiest gains of the initial market rebound may have been made, but the picture surrounding consumer balance sheets, corporate profits, inventories, and real interest rates offers potential further upside drivers.

    Investors need to tread more carefully, though, supporting our recent call that, while equities may have a tougher time over the rest of the year, areas like low duration high yield, structured credit and selective exposure to emerging markets could be well-placed in the current environment at the right entry points.

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