It’s Fed Day on Wednesday and an expected rate hike but a lot less certainty around whether the FOMC has any more plans to raise rates. Markets see a roughly 95% chance the Fed goes for another hike and roughly 80% likelihood it follows this with another 25bps hike in March.
Beyond that the outlook is much less clear – only a one in three chance of another 25bps in May as markets bet that the Fed is close to the top. The meeting and press conference will be crucial as Jay Powell either pushes back against the dovish market pricing or instead leans into the narrative that inflation has peaked and a pause is warranted.
Here the the five key issues to ponder as we approach another inflection point:
The futures market and the Fed don’t have consensus
Futures point to the market thinking the Fed will stop between 4.75-5.0%, in other words one more 25bps hike in March after 25bps on Wednesday. Markets are also pricing in cuts later this year. But Fed officials, by way of the dot plot, think the terminal rate will be some way above 5% and stay there for all of 2023. It is possible even they are underestimating the scale of the problem and a 6% level is eminently possible. On Wednesday they could prefer to slow to 25bps but this is not the same as a stop and pivot. Is the market mispricing the terminal rate and misjudging how long the Fed will keep them there before it cuts?
US GDP is decelerating
US GDP expanded by more than expected in the final quarter of last year, however this might be the last positive print for a while as there are clear signs of deceleration at the start of 2023. Final sales to consumers rose just 0.2% in the fourth quarter and fixed investment declined 6.7%. January PMIs are in contraction territory. There are signs that the Fed’s hikes are starting to have an impact, albeit the labour market remains tight, partly for structural reasons.
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US inflation is cooling, but it’s not over folks
Inflation has shown clear signs of cooling. PCE inflation has fallen from 6.3% in September last year to 5.0%, whilst core PCE inflation has declined to 4.4% from 5.2% over the same period. The thinking is that disinflation allows the Fed to slow down and signal that a final 25bps in March could be its last for now. However, slowing is not the same as coming down to target and the Fed is saying to the market that it won’t pivot soon. The setup seems to allow the Fed to slow and check the rear-view mirror. Looking forward, there are signs that inflation is broadening and become embedded to a degree that will force the Fed to push on further. Commodity inflation may be rearing its head again.
FOMC members want to slow rate hikes
Minutes from the last Federal Open Market Committee meeting show most members reckon they should start slowing the pace of rate hikes soon. This was not a significant surprise, if indeed it’s surprising at all. Mostly we knew that the Fed was wanting to take its foot off the gas a bit as we round the corner of the year into 2023 to allow time to take a look in the rear-view mirror to see if the economy was catching up with the breakneck pace of hikes.
Quantitative tightening probably still off the table
The Fed could actively start selling bonds but this would cause significant disruption in the market. The Fed looks quite happy with QT chugging along in the background without too many ructions or tantrums. Any talk about juicing QT would spark significant volatility in rates. So we await with interest any talk about this since the Fed must surely be annoyed that long-end rates remain so persistently low, running counter to its hiking. The 10yr remains stubbornly at 3.5% and a nod to doing something with QT might push this rate up, so it could be an option for the Fed to try to get the market closer to where it’s thinking.
“One of the reasons I think the Fed sticks to a hawkish line is the market interpretation remains so dovish – pricing in cuts this year when the dot plots don’t suggest this at all,” said Neil Wilson, Chief Market Analyst at CFD broker Finalto. “The Fed does not want to see further loosening in financial conditions – not yet. We’ve seen the dollar roll over as the focus shifted from the Fed to the ECB and Bank of Japan. The Fed is seen being pretty well near the top of the cycle, whilst the ECB is trying to catch up and the BoJ is yet to join the party. That’s been a headwind for the dollar in recent months but a more persistently hawkish Fed can act as a tailwind this year.”