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Federal Reserve on track for another 75 basis point hike

Following US inflation of 9.1% and the Bank of Canada’s surprise 100 basis point rate hike, the market accepted the idea that the Federal Reserve might follow suit. On July 13, a 91bp base was set for the July 27 FOMC meeting decision, but comments from two of the most notable hawks (St Louis Fed Chairman James Bullard and Board Member governors Chris Waller) quickly raised doubts. While all the options were on the table, they indicated they wanted to see solid numbers between then and July 27 to convince them that 75 basis points was not the best option.

Last week’s retail sales and industrial production numbers were mixed and this week’s housing numbers were poor. Last Friday’s University of Michigan Confidence Index showed household confidence in dire straits as, crucially, long-term inflation expectations fell. Waller had suggested that “if the data is slightly stronger than expected, that would tip me toward a bigger upside at the July meeting.” They certainly didn’t, so if Waller and Bullard don’t vote for 100 basis points, it’s not going to happen.

That leaves a 75 basis point hike as the strong call with three out of 62 banks surveyed by Bloomberg forecasting a “dovish” 50 basis point hike and only one forecasting a more hawkish 100 basis point move. We are well in the 75bp camp with ongoing quantitative tightening to be confirmed as the market hedges a little, expecting around 80bp upside.

Another 125 basis points of increases likely before the end of the year
It is clear that the Fed is not going to stop there. They accepted that supply-side improvements will not come to their rescue in bringing inflation down – hence the abandonment of the “transitional” narrative – and they acknowledged that it was their job to rein in demand through higher interest rates. .

Recent declines in gasoline prices have offered some encouragement that 9.1% likely marks the peak of US inflation, but it is likely to remain stubbornly high for at least the next six months. There are few signs of easing from price pressures around food and soaring airfares, while the lagged effects of a scorching real estate market continue to trickle down to housing components. The good employment figures recorded in recent months, with unemployment at just 3.6%, also indicate further rate hikes to come.

They will likely leave hints about the magnitude of the next wave ahead of their September FOMC and forecast update, preferring to watch the data. Nonetheless, we believe this will be the last 75bps hike and expect 50bps hikes in September and November with a final move of 25bps in December.

Inflation could fall rapidly next year
As for next year, we strongly suspect that rate cuts will be the key theme. By delaying their response to high inflation and now having to steer policy faster and deeper into restrictive territory, there is clearly the fear of a recession. At the same time, we think inflation could fall sharply from March next year.

The ongoing real estate recession is expected to significantly slow house price inflation and lead to a more modest contribution of the house rental components to the CPI (35% weighting). We believe this could reduce the annual inflation rate by two percentage points. Used car prices weigh 4.1% and have risen 53% since February 2020. We see weaker demand and increased supply for new cars likely to trigger significant price declines that further subtract a two percentage points to headline inflation. Then with interest rates dampening activity, which will likely squeeze corporate profit margins, and some supply chain improvements, I think we can get back to 2% by the end of the year. If gasoline prices fell back to $3/gallon, we could even be talking about inflation below 1%!

Rate cuts in sight for summer 2023
The economy has been in a state of massive flux over the past two years and there are many avenues it could still take. But our mindset is changing to one where the authorities are frantically trying to get the inflation picture under control, but may end up overstepping the bounds. Credit spreads are widening and the dollar is up 12% this year and stocks are down almost 20%. Add sharp increases in interest rates as the Fed brakes hard and we could have both the economy and inflation over-compressed.

Moreover, interest rates do not stay high for long in the United States. Over the past 50 years, the average time between the last Fed rate hike in a cycle and the first rate cut has been just six months. This suggests that the door could be open to rate cuts as early as next summer.

Easing market inflation expectations present a positive picture
The signal from the yield curve is that market rates have peaked in the 3.5% area. This is where the US curve belly came in about a month ago (the 5yr actually hit 3.6%), and since then the curve belly has grown significantly, which suggests that we have seen the peak in market rates. The Fed will see it, it will also see the significant drop in market inflation expectations (correlated to the drop in nominal rates). The fall in the 10-year break-even inflation rate to 2.4% (from a peak of 3%) is impressive, but even more striking was the drop in the 2-year break-even inflation rate from 4.5% to mid-June to just over 3% now.

These market pressures point to 1. a reduced need to accelerate the pace of tightening (75 bps is good), and 2. the possibility of reducing the pace of tightening in future meetings (say to 50 bps). The US yield curve is now under flattening pressure as the Fed continues to rise. As the bulls begin to slow (which we see in the fall), the next big move will be a steepening from the start as the curve begins to prepare for potential cuts sometime in 2023.

The technical conditions of the money market, however, are not very attractive
We will be interested to see if the Fed pays more attention to the technical aspects of the front end. Since the June FOMC meeting, the repo facility rate has been set at 1.55%. However, SOFR did not reach this rate, reaching only 1.54%. In fact, it was initially in the low 1.40% range after the Fed hike, as it failed to even get close to the fed funds floor. This correlates with the return of more than $2 billion to the Fed on this facility, as the Fed’s offered rate of 1.55% is clearly an attraction for money market funds. Not a big deal. But at the same time not a great look. It also takes liquidity away from the repo market itself.

So far, the Fed has viewed this as a convenience doing its job during a period when there is clearly excess liquidity remaining in the system. At the same time, the Fed could also choose to combat this by accelerating the roll-off of bonds on its balance sheet. They are unlikely to do so as the focus at the moment is on getting the funds rate where it needs to be. But it should always be part of the conversation the Fed needs to have with the market.

FX: the Fed still offers a floor for the dollar
The dollar’s correction at the start of the week seemed tied not only to some recovery in risk sentiment, but also to the growing narrative that other major central banks could close the gap with the Fed. How this second theme affects the FX market obviously has to do with the extent of the tightening already priced in for the Fed and other central banks. We continue to emphasize that Fed prices are in line with the Dot Plot projections and we do not consider them too aggressive given that the US still has good economic momentum and less exposure to geopolitical/commodity shocks .

On the other hand, companies like the European Central Bank and the Bank of England still see market prices in a very hawkish tightening trajectory, somewhat detached from evidence of an impending downturn and major exposure. to global risks, which increases the risk of a dovish tightening. revaluation hitting their currencies.

With that in mind, unless the Fed sends dovish signals along the lines of July’s policy announcement, we think the 75 basis point rate hike may fit well into a broadly supportive rhetoric for the dollar. in monetary terms.

We still believe that the dollar will start to decline slightly in the fall, but the risks to this scenario are admittedly high and mainly come down to the extent of the growth divergence between the United States and other parts of the world. (especially Europe).
Source: ING