“We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent.”
— Chair Powell, Federal Reserve
Firstly, what a week, right?
Let’s dive into the meat, and as usual, lend me your attention from here onwards.
Successive 75bps Hikes, Enough To Solve Inflation?
It’s set in stone, if you were anticipating a Fed Pivot, i.e a diversion from their aggressive monetary policy stance, you can say goodbye to that dream. Rates are up 75bs to 3.25% in the U.S, and it’s about to get hotter.
Let’s dissect the newly released Summary of Economic Projections (SEP)from the Fed.
Now, what’s the first thing you notice when comparing some of the projections to the previous June release?
It’s the change in expectations for real GDP growth this year and in 2023. Initially, in June ‘22 the Fed projected real GDP growth to be at 1.7% whereas projections now are showing revisions for real GDP growth to be subdued at 0.2% a whole (1.5%) cut!
Fed Jay Powell pointed toward “high-interest rates” as the reason we’re seeing such low revisions for economic growth.
The question is, how did markets perceive the initial release and what is the market pricing for the future?
To answer that, let’s take another look at the Federal funds rate projections vs the June figures. What markets instantly would have seen is that now interest rates in the U.S are expected to rise higher than previous projections and stay elevated/ in restrictive territory for a longer period of time. And if you’re judging how restrictive rates will be, the neutral rate is 2.50%, and we’re expected to see interest rates climb 200bps above neutral rates. That just goes to show how serious the Fed is about getting to its inflation target.
You might be thinking, why does that matter?
Here’s why. What affects the wider scale economy isn’t just what interest rates are, whether restrictive or accommodative, it is the duration, the length of time financial conditions are either loose or tight. So, if we experience a tightening in financial conditions only up until mid-2024, a shorter time window as seen in the June SEP revision, you would expect asset markets to take a relatively small downturn as seen, in anticipation that the Fed will have to pivot from their aggressive stance at some point to support the economy, eventually boosting risk assets once again. However, what we’re seeing now with the recent SEP revision, is that the Fed will now maintain a tightly restrictive monetary policy for much longer with rates expected to reach highs of up to 4.75% as shown in the dot plot below.
The main point, I want you to take away from this dot plot which simply shows all 19 FOMC member’s projections of interest rates for the years 2022 - 2025, is the level at which members expect rates to be in order to get inflation under control. That being between 4.50% and 5.00% by 2023 vs the June expectation of 3.50% and 4.25% by 2023.
That shift only signals more hawkish behaviour from the Fed and further pain for stocks, crypto, EM & G-7 currency valuations which have already taken a hit YTD.
In short, I think the Fed has made the correct step in its monetary policy stance which is to bring back inflation to 2%, through successive rate hikes and balance sheet reductions (something we’ll look at later). My central focus will be on how equities price in tighter financial conditions for longer as well as how leading economic indicators will react.
Bank Of England Join The Party: 50bps
Very similar to what we have going on in the U.S; the BoE stepped up its interest rate expectations after raising its base rate to 2.50% from 1.75% on Thursday.
I must say, the narrative in the Uk in regard to where we are headed as a nation is a forever dwindling picture. Amidst all of the rate hikes, cost of living remains the biggest soreness within the economy. A testimony to the current weakness is the rate at which the BoE stepped up interest rates. Remember, at the end of the day what really matters most to central banks, is their credibility.
Now onto an even bigger focal point, when assessing the relative strength of a currency relative to the G-7 basket one of the first things you would look at would be the IRD (interest rate differentials). With the Fed recently hiking rates by 75bps, the ECB by 75bps and even the SNB (Swiss National Bank) hiking rates by 75bps, you have to ask.
How is the strength of the UK’s economy perceived by the world against other major economies?
Especially when the BoE is only able to deliver a 50bps hike unlike its G7 counterparts. Yes, you may be thinking we are ahead on the hiking cycle, having a positive rate differential vs ECB & SNB, but the important factor at play is the ‘rate of change’ and monetary policy stance. Even though rates may be higher in the Uk economy, if the future economic picture is looking weaker, that will translate through to monetary policy conditions materially softening resulting in lower rate hike increases like the one we just saw. That is the ebb and flow of where the Uk is positioned.
I know we saw some really interesting action from the BoJ this week as they intervened to stop the Yen from sliding! I will save that for a detailed piece coming out on Tuesday; as for now - thanks for reading and supporting as always.
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Until next time. MMH