Fed hiking cycle: What next?

It is now abundantly clear to most investors that the Federal Reserve in the US has underestimated inflation and fallen significantly behind the curve. The same comment can be made for most developed world central banks in differing degrees. Inflation is a problem across the world and this genie will not go back into its bottle easily.

Over the past 12 months, inflation expectations have been consistently too low, and each new data point has forced the consensus to raise forecasts. This pattern is especially pronounced in the US. This raises the dangerous spectre that current forecasts for much higher inflation are still not high enough. For context, it is quite astonishing that exactly 12 months ago, expectations for the CPI (consumer price index) in Q1 2022 were only slightly above 2 per cent. This number will come in close to 8 per cent, a monumental miss in expectations. The Federal Reserve will have to hike rates fast and far to ensure that inflation does not run away from us and get embedded in expectations. The Fed has already hiked rates by 25 basis points in its mid-March meeting and the market expects another 170-180 basis points of additional hikes in 2022. Given that we have only six more meetings in 2022, we are likely to see at least one hike of 50 basis points or more. In addition to the hikes, we are going to see a balance sheet run-off in 2022 as the Fed has stopped buying bonds. This balance sheet shrinkage will be the equivalent of another 25 basis point hike. Despite what looks like a sharp hiking cycle, in the context of financial history this may not be quick enough.

Illustration by Binay Sinha

The Fed has begun the hiking cycle with the CPI at 8 per cent, and yet we are building in only 200 basis points of hikes in year 1. Since WW II, there has only been one rate cycle where the CPI at the start of the hikes was higher than 8 per cent (1980). In that cycle, rates rose by 600 basis points in year 1. In almost all other rate cycles, the CPI at the point of the first hike was at 4 per cent or less. While it is true that the 8 per cent CPI is an overstatement, given the base effects and energy/food prices, still core personal consumption expenditure (PCE) is over 5 per cent, and 94 per cent of the underlying good and services in the PCE basket has experienced rising prices in the last 90 days (source: DB), showing the breadth of price pressures. In the Fed’s own forecasts they have the core PCE not coming below 2 per cent (their target), even through 2024.

Understanding the seriousness of the inflation threat, the Fed has clearly indicated it will move monetary policy into the restrictive zone, rather than just removing the extraordinary accommodation. The Fed expects its policy rate to reach near 2 per cent by the end of 2022 and eventually hitting 2.75 per cent by year-end 2023 and then staying there through 2024. The rate 2.75 per cent is above the Fed’s own estimate of the long-term neutral rate of 2.3-2.4 per cent. This rate guidance implies that the Fed recognises that inflation can be defeated only by consciously slowing the economy and hitting demand through tightening rather than simply normalising rates. In addition to the rate hikes, various investment banks estimate that the effects of the Fed balance sheet run-off will be the equivalent of another three-four rate hikes through 2023.

Given all this tightening, what is likely to happen to markets and asset classes?

At first given the leads and lags, not much will happen in markets in the initial 12 months if history is any guide. There have been 13 Fed rate-hike cycles since World War II, the earliest recession following the first hike was 11 months, while the average recession is about three years from the first hike. There have been four cycles where a recession came more than 50 months later.

This period is, however, a little different as we are entering the cycle, with a weakening economy. Consumer sentiment measures in the US place a near 50 per cent probability of a recession in the near term. The 2-10-year yield curve is only 20 basis points at the start of the tightening cycle, far below the 157 basis points reached in early 2021. Every recession since WW II has been preceded by an inversion of the 2-10-year curve. A recession normally hits within 8-18 months of the inversion. Policy rate futures are inverted, and despite the Fed rate guidance discussed above, markets do not believe, pricing in rate cuts beginning in late 2023.

While the Federal Reserve is obviously targeting a soft landing, it seems a very narrow window is open. With the spike in inflation, the Fed is being forced to hike into a slowing economy, compounded by a war and supply shocks across the commodity complex. Can policymakers in the US get ahead of inflation without tanking the economy? Alternatively, if they choose to err on the side of saving the economy, will inflation not become entrenched? A very difficult choice and one which at a minimum will cause serious market volatility.

Long bond yields are also facing conflicting forces. The weakening economic outlook is driving real yields down, while inflation expectations are rising. At the moment, we have seen 10-year bond yields in the US cross 2.45 per cent, and probably headed higher. The fact remains that for almost every investor active today, they have only seen 10-year bond yields trend down, since 1982, with little respite. Whenever we have reached the top of this downwards sloping trend line, with yields threatening to break out, a market accident has forced the Fed to intervene and yields have backed down again, only to reach further new lows. We had the Black Monday crash of 1987, the Orange County derivatives debacle of 1994, the dot com bubble bursting in 2000 and the global financial crisis in 2007. Even in 2018, we had the vicious Christmas Eve massacre in equities. Each time the Fed came in, cut rates, and calmed markets.

We are again now breaking out of the long-term downward trend line in 10-year yields. The rise in yields is bound to create an accident in some asset class, somewhere, given the rise in leverage and the easy availability of liquidity and search for yield and growth. The problem this time is if the Fed will be able to come in and calm markets, with inflation at 8 per cent? In all the previous cycles, the Fed did not have to worry about inflation and its own credibility as an inflation fighter. This is no longer true today. There is far less freedom for policymakers in the US today. They cannot wish away their inflation problems. We may need to be prepared for greater volatility in asset markets and no Fed riding to the rescue to save markets. A different construct from the past 40 years, when markets were convinced that the Fed had their back. There may be no longer any Fed put, at least not in this cycle.

The writer is with Amansa Capital