- FOMC decision: 75 basis points (bps) rate hike in line with market expectations and Fed guidance;
- Going forward, the pace of rate hikes should slow and will depend on macro data;
- Fed fund rates are getting closer to where they should be, fuelling optimism in markets that Fed will become less hawkish in the coming months;
- Massive market reaction on the 27 July (Nasdaq +4%) may be a bit excessive though, and investors should keep in mind that i.) rate hikes are not over yet ii.) recession risks are still looming iii.) there is no evidence yet that the Fed has won the battle against inflation;
- Investors should therefore be neutral on long-term interest rates and continue to focus on quality stocks and profitable growth, but it is too soon to become aggressive on risk taking.
What was really at stake on the 27 July?
There were no surprises in monetary policy yesterday in Washington. On the 27 July, the Fed confirmed its 75 basis points interest rate hike that has been on the table for several weeks, and well-priced in already.
Markets were more looking out for the tone of Jerome Powell’s speech and of the Q&A session, his perception of the recession risk (which received most questions) summoned by the press as well as his comments on the future path of action.
A tight path for the Fed
Indeed, the Fed is walking on a tight rope. It has repeatedly highlighted that it needs to cool down economic activity below potential - notably the very strong job market conditions - in order to return inflation towards its target, but without leading the economy into recession.
On this point, the Fed seemed relatively confident that the US was not in a recession “as we speak”, and the monetary toolbox and policy approach have the capacity to adjust financial conditions in a pragmatic and data dependent manner without excess. Powell kept on insisting that the jobs market remains very strong even if job creations started to slow.
Is the Fed overly optimistic on recession risk, as it was too optimistic regarding temporary inflation?
That is of course our main risk and the topic of many questions during the conference. Indeed, we have had a Q2 GDP release in slight contraction (-0.9% in annualised quarterly terms), notably due to inventories and investments negatively affecting output despite exports and consumption that grew moderately. While refusing to bring an alternative definition for recession, J. Powell highlighted that the US economy is not showing signs of a « broad-based decline » of activity affecting many sectors, suggesting that a technical contraction in GDP would not be sufficient to derail the Fed’s agenda.
Why are markets reacting positively to this no-surprise meeting?
Markets mostly bought the idea that 2022 Fed policy is in fact a two-step process and not on a pre-set course. After front-loading jumbo rate hikes intended to bring the Fed funds rate as fast as possible to what is considered by J. Powell as close to neutral rates (2.25% to 2.5%), the future path of action will be totally data-dependent, and probably conducted at a slower pace. J. Powell still thinks that the economy requires interest rates that are somewhat a bit more restrictive. Moreover, if we integrate transmission delays of monetary policy, he mentioned that « more tightening is already in the pipeline ».
Is the battle on inflation already won as market inflation expectations have already started to cool?
It is a tempting posture for those who think that the role of monetary policy mostly relies on managing inflation expectations. J. Powell seems satisfied to see inflation breakevens going down (Chart 1), reflecting market confidence in the Fed’s commitment to fight inflation. However, given the level of surprises on inflation in the past year, J. Powell wanted to see evidences that realised inflation is actually going down.
What then is on the table for the next FOMC meetings?
A 50 bps hike in September remains the central case, but as mentioned on the 27 of July by the Fed, we will receive two monthly sets of data on inflation and unemployment that may affect the direction of monetary policy. Beyond September, the message is that rate hikes should slow down to 25 bps hikes, largely depending on incoming data and the economic outlook. Even if forward guidance is buried, J. Powell implicitly maintained the idea that at this stage taking Fed funds to 3% at year-end is probably the adequate guide to Fed actions.
Is there a risk that being too focused on inflation could lead to market dislocation?
J. Powell considers that a tighter monetary policy naturally means tighter financial conditions and asset valuation adjustments, which are necessary. However, there are according to the Fed no signs of financial dislocation or disappearing liquidity, and this repricing of risk premiums does not constitute a worrisome taper tantrum. The underlying message is that the Fed is not worried by the market direction of the past months.
What are the implications from an asset allocation standpoint?
- Firstly, it confirms the more constructive stance on long-term rates expressed since June through an increase in exposure to sovereign bonds in managed portfolios.
- Secondly, we believe that it is a supportive message for equity markets and notably for Quality / Growth stocks that have suffered from valuation adjustments in relation to bond yields.
- Thirdly, we could see also a positive reaction in credit spreads after significant widening in the past months, notably for quality bonds (Investment Grade).
- However, investors should refrain from being too optimistic and anticipating a massive market rebound. It happened several times in the past that after an initial strong positive reaction to a Fed meeting, the market resumed its correction trend.
- Furthermore, the market reading is suggesting that the Fed is on its way to stop rate hikes before year-end and could signal more dovishness at the Jackson Hole Symposium in August. It is probably premature to believe so, and will remain data dependent. We should also keep in mind that i.) that the Fed still intends to continue its tightening and returning to a « neutral balance sheet »which could take two years according to J. Powell, and ii.) that reducing the pace of future rate hikes does not yet mean a reversal in Fed policy.
Chart 1: US inflation breakevens
Sources: Refinitiv, Indosuez Wealth Management.
July 28, 2022