- The Federal Reserve raised the Fed funds rate by 50 basis points as expected, taking the target range to 4.25-4.5% and suggesting that the terminal rate could be 5.125% as they think inflation will be stickier than they previously thought. As the higher terminal Fed funds rate should weigh on growth, the Fed now expects the economy to grow 0.5% in 2023, and the unemployment rate to rise higher to 4.6% and remain there through the three-year time horizon.
- We continue to believe that the Fed will raise Fed funds by another 50bps to 5% in February, and the rate will stay at that level throughout 2023, in contrast with the market’s hopes for cuts. We’ll have to wait till Q2 2024 to see the first 0.25% cut, followed by another 0.25% in Q3 2024.
- Amid the global slowdown, our equity strategy remains focused on quality companies that generate cash, earnings, and maintain low levels of debt. We maintain a defensive sector posture and continue to prefer the US (and Asia) over Europe. For bonds, we favour investment grade DM corporate bonds and high quality EM credits, and take more duration risk in government bonds (medium durations) vs credit (short-to-medium durations). The support for USD is less as we are close to the end of the rate hikes but slowing global cyclical momentum should reduce the downside for USD, especially after the sharp move of the past few weeks.
- As expected the Fed raised the Fed funds rate by 50bps, taking the target range to 4.25-4.5%. While the Fed did send a very clear signal by slowing the pace of rate hikes, it also sent a very clear signal by suggesting they were not done tightening. In fact, in the Summary of Economic Projections, the Fed suggested that the terminal rate for the Fed funds rate could be 5.125% in 2023, which is higher than the 4.6% terminal rate they had forecast in September. The Fed also made it clear that they would remain vigilant and restrictive for a protracted period of time to ensure that inflation returns to its long-term 2% symmetric target.
Inflation set to slow according to the Fed
Median of the FOMC economic projections, December 2022
Source: Federal Reserve, Bloomberg, HSBC as at 14 December 2022.
- The press release stated that “ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time”. That’s a clear signal to markets that the FOMC is not done raising interest rates yet. We believe the Fed will raise Fed funds by another 50bps at its February meeting, pushing the target range to 4.75-5%. We recognise that there’s an upside risk to this forecast if inflation doesn’t slow sufficiently by the time they meet in March.
- We take comfort that the press release also stated that “the committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation and economic and financial developments”. It seems clear that the FOMC is concerned that the rapid pace of rate hikes may have a more adverse effect on the economy and financial markets than originally intended. As a result, it seems likely that the Fed may choose to pause, not pivot, once the terminal rate rises above 5%.
- Financial markets are concerned that the Summary of Economic Projections showed the Fed funds rate peaking at 5.125% instead of the 4.6% originally forecast in September. The higher terminal rate for Fed funds is also reflected in the changes in their views on the economy.
The Fed potentially could raise rates only one more time
Source: Federal Reserve, Bloomberg, HSBC as at 14 December 2022.
- For 2023 the Fed believes the economy will only grow 0.5%, which is much lower than forecast in September (though close to market consensus and our own estimate). In addition, the Fed forecasts the unemployment rate rising higher to 4.6% and remaining there through the three-year time horizon. The good news is that the Fed believes the PCE inflation rate should slow to 3.1% in 2023 and 2.5% in 2024, suggesting that they remain confident in their ability to slow inflation. The FOMC also made it clear that economic weakness in 2022 and 2023, given the higher interest rate structure, could lead the Fed to lower interest rates in 2024 and 2025 back to 3.1%.
- Unsurprisingly, the credit market reacted to the combination of the Fed’s somewhat hawkish tone and downgrades to growth by pushing up the 2-year Treasury yield but lowering the yield of the 10-year ‘safe haven’ Treasury. Cyclical stocks were lower overnight and the USD received some support.
- The FOMC’ December meeting decision was not a surprise, but the bearish economic view and the higher forecast for the terminal Fed funds rate have given markets cause for concern. Clearly, the Fed will need to see continued improvement in inflation, or disinflation, if we are to see the Fed pause in the first quarter of next year. The Fed seems to recognise that inflation and wages need to slow which will necessitate a higher unemployment rate and a period of below-trend growth. It’s important to remember that we are probably nearer the end of the Fed tightening cycle which will give the markets ample time to analyse the fundamentals of the economy and the financial markets to make appropriate investment decisions.
- In equities, we continue to focus on quality companies that generate cash, earnings, and maintain low levels of debt. We maintain a more defensive posture in our sector selection to that end. In the next few months, markets will probably re-price equities yet again, this time reflecting the double whammy of slower demand and compressed margins and the resulting downgrade of earnings expectations for the next year. While higher interest rates clearly may take a bite out of equities, US equities should fare better than most markets, even with the potential for slower growth, which is why we maintain our overweight on US equity markets.
- For fixed income investors, higher rates provide selective opportunities and we maintain our focus on investment grade, as well as emerging market credits. We maintain short-to-medium duration strategies in credit and medium durations in Treasuries, as higher policy rates should continue to drive market rates higher. If economic growth slows more or if the Fed raises rates higher than expected, investors will seek the security of quality US fixed income markets.
- The US dollar has fallen significantly in recent weeks, on hopes of a quick pivot but the downside to global growth suggests some support. In summary, we think a broad sideways path for USD is more logical than the sharp decline we have seen.
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