Disagreement between the Fed and investors could bring more volatility
- We expect the Fed to raise policy rates by 25bps in both FOMC meetings in 1Q 2023
- Fed officials remain firm on high rates for longer, contrasting with market view of rate cut before the end of 2023
- Investors should focus on short duration, high quality U.S. fixed income
We expect the U.S. Federal Reserve (the Fed) to raise the official policy rates by 25 basis points (bps) at its Jan 31-Feb 1 Federal Open Market Committee (FOMC) meeting, and again when its meets in mid-March. This would take the Fed Funds Rate to 5%. While there are signs that both the economy and inflation are cooling, Fed’s officials’ determination to put inflation away with tight monetary policy has not changed. A 5% policy rate by the end of the first quarter is already reflected by the futures market, what happens beyond in the rest of 2023 and 2024 is less clear.
Where there are discrepancies between Fed officials and the market is the rate path late in 2023 and 2024. According to the last set of Summary of Economic Projections from December, the Fed’s view is that the interest rates would need to remain elevated throughout 2023, and going into 2024, to bring inflation in line with the policy target. However, the futures markets is now pricing a total of 45bps rate cut before the end of 2023, reflecting investors’ pessimism on economic growth and the need for the Fed to change course, by prioritizing growth over inflation once again once price momentum eases.
The U.S. economy expanded by 2.9% in 4Q 2022 at an annualized rate, versus 3.2% in 3Q 2022. However, real consumer spending, light-vehicle sales and single-family building permits all slowed during the quarter. Moreover, the personal saving rate has fallen to 2.9% from 7.5% a year ago, with higher credit card debt. This reflects that households are trying to maintain their spending levels even as the government’s fiscal support during the pandemic era has come to an end. This is not sustainable and could lead to a cut back in consumption in 2023.
With the economy slowing on several fronts, it is reasonable to expect the U.S. to contract at some point in 2023. That said, a resilient banking sector, and modest debt level for both households and the corporate sector point towards only a shallow recession, instead of a severe one.
On inflation, the average monthly increase in CPI for the past six months was less than 0.2%, indicating that the overall price momentum is moderating. The slower price increase in core goods played a key role here. Even though a weaker U.S. dollar and energy price volatility may lift inflation momentum in 1H 2023, lower rents and slowing housing market activity should help to cool inflation further in 2H 2023. Overall, core rates of inflation won’t reach the Fed’s target of 2% by the end of 2023, but it should be making solid progress in getting there by 2024.
Exhibit 1: Federal funds rate expectations
Market expectations for the fed funds rate
The tricky part for investors is that the latest set of economic data provide ammunition to both the doves (market) and hawks (the Fed). For the hawks, the economy is not slowing enough to bring inflation momentum down in a material way, especially looking at the solid job market. Fed officials have been vocal about the willingness to tolerate weak growth, even a mild recession, in order to achieve its price stability objective. For the doves, projection of weaker growth and slowing inflation should persuade the Fed to back down from its tough stance on cooling the economy in order to stabilize prices.
The risk is that the Fed’s stance is going to prevail in the near term, and this could put upwards pressure on U.S. Treasury bond yields and for the Treasury curve to flatten. This could then bring back some valuation de-rating in U.S. equities and spread widening in U.S. high yield corporate debt. This is part of the reason for us to recommend Asia Pacific investors to focus on short duration, high quality U.S. fixed income for now, until there are clearer signs of the end of policy tightening.