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Economic data from the US has been robust since the start of year. Following on from a much stronger than expected January non-farm payrolls report, alongside substantial upgrades for the preceding two months, price pressures in January also exceeded expectations. CPI inflation in the US is now running at its fastest pace in 40 years with the index up 7.5% y/y in January. More worrying for consumers and businesses is that core inflation, stripping out the volatile measures of energy and food costs, was up 6%, showing how broad and entrenched higher prices have become in the US.
In that context of a labour market in full recovery and high prices, the imperative for the Federal Reserve to move much more aggressively is clear. Following on the January inflation print swaps markets swung considerably to pricing in a 50bps hike at the March FOMC meeting, a move that had been considered by several regional Fed presidents and wasn’t ruled out by Jerome Powell in the press conference of the January meeting. James Bullard, the president of the St Louis Fed, came out in support of a full 100bps increase in rates by July 1st, which would mean at least one 50bps hike at an upcoming FOMC. With few signs that inflation will ease materially over the next several weeks the macroeconomic and market conditions are aligning to support such a sharp move higher in the Fed funds rate and we are shifting our own rate expectations higher as well.
US rate expectations revised upward
We now expect that the Fed will move with a 50bps hike in March followed by 25bps hikes at its sequential meetings up to September. We would also expect to see the Fed begin its process of balance sheet reduction by Q3 at the latest, helping to tighten financial conditions further. After September we expect one more hike at either the November or December meeting. That would bring rates up to 2% by the end of this year. For 2023 we are penciling in another two hikes to bring the terminal rate for the Fed funds rate to 2.5%, the same level it reached at the end of the Fed’s last hiking cycle from 2015-18.
There is a sizeable risk to our expectation of a 50bps hike, however, should Fed policymakers choose to take a more cautious and steady approach, increasing by 25bps instead. But in that scenario we would still expect the Fed to tighten policy via an earlier start to balance sheet reduction. In the end, financial conditions are likely to get to the same tighter place by the middle of the year; it’s a question more of which path the Fed chooses to take.
Yields to follow rate move
Such a material tightening of US monetary policy will yank yields higher as well and we are revising up our expectations for US Treasury yields to 1.9% on the 2yr by year end and the 10yr at 2.5%. Since the start of the year the US yield curve has gone through a relentless flattening. The spread between 2yr and 10yr UST yields has fallen to around 45bps from closer to 90bps at the start of 2022 and down considerably from almost 160bps a year ago.
We do not expect that the flatter yield curve is a lead up to a contraction in the US economy but instead reflects the markets pricing in the Federal Reserve normalizing policy. Yields on the front end of the UST curve have jumped considerably since the December FOMC when the Fed retired its transitory description of inflation and the dots plot sketched out three hikes for 2022. The 2yr UST yield for instance has gained more than 90bps since the December meeting while the 10yr yield has added around 57bps. We expect this yield curve compression will continue as the Fed starts its rate hiking cycle but that the curve will begin to normalize by the end of the year, provided that growth is not materially derailed by higher interest rates.
Not just a US phenomenon
Central banks globally are being challenged by entrenched inflation and we would expect hawkish voices to become louder as the year goes on. For the Bank of England we expect to see rates moving up to 1% by the middle of the year, accompanied by a more active quantitative tightening. Slowing growth, supply chain issues and an appreciating currency may deter the BoE from raising rates much more in H2, although we think another 25bps is likely in H2. The ECB also looks to have finally acknowledged the threat inflation poses to its outlook but still has far less unanimity on the path for policy than the Fed does, to our view. We have pencilled in the potential for a 10bps increase in the ECB deposit rate but only much later in the year. Among the other major developed market central banks we see no movement from the Bank of Japan this year while central banks in Canada, Australia and New Zealand will likely take more steps to tighten policy.
Edward Bell
