Investment strategy
September 21, 2022

Brace for impact: Fed raises interest rates again by 75bps to 3.25%

September 21, 2022
Bruce Harris
Head of Global Fixed Income Strategy
SUMMARY

At its September meeting, the US Federal Reserve’s Federal Open Market Committee (FOMC) again raised the interest rate by 75bps (3.00%-3.25%). This marks the third successive 75bps hike. Investors may potentially view the development as an opportunity to obtain quality fixed income exposure.


  • While there had been some market discussion last week about the possibility of a 100bps hike following a strong August core CPI reading, the Fed stayed with 75bps. Other policy rates such as the interest rate on excess reserves (IOER – rate paid to banks for reserves) and the overnight reverse repo rate (RRP -rate paid to funds for overnight deposits) were also raised to 3.15% and 3.05% respectively.
  • The dot plot, or the 18 committee members’ current expectation for future rate hikes (it is not a committee forecast), was adjusted higher yet again and now implies almost five additional 25bps rate hikes to take Fed Funds to 4.4% by the end of 2022. The dot plot also shows an additional rate hike in 2023 to reach the terminal rate of 4.60%.
  • The Fed’s quantitative tightening program should now start to approach the target of $95 billion of balance sheet reduction per month, of which $60 billion will be in Treasuries and $35 billion in mortgage-backed securities (MBS). While the balance sheet declined very little over the summer, the impact of future reductions should start to become clearer within a few months as various reinvestment and trade settlement issues for MBS are resolved.
  • The Fed adjusted 2022 projected median Core PCE inflation up from 4.3% to 4.5%, while 2023 was adjusted higher from 2.6% to 2.8%. The projected unemployment rate slightly increased from 3.7% to 3.8% for 2022, and from 3.9% to 4.4% for 2023. The magnitude of employment losses in the future will likely be a key factor in the Fed’s calculus on when it will end its rate-hiking cycle, and perhaps adjust with rate cuts.
  • The projection for real GDP growth sharply declined 1.7% to 0.2% in 2022 and also decreased from 1.7 to 1.2% for 2023. These are much lower growth forecasts but given that they are still positive also indicate that the Fed will try to maintain higher rate levels. The FOMC statement also said – as it has many times this year - that it was strongly committed to returning inflation to its 2% objective.

Our takeaways

  • Overall, the FOMC statement and dot plot projections were slightly more hawkish than expected by the market, especially given the new information that the Fed would try and keep Fed Funds above 4.5% for 2023.
  • Given Chairman Jerome Powell’s very hawkish Jackson Hole speech combined with the FOMC’s hawkish tilt on September 21st, it seems clear that the Fed appears determined to adopt the approach of more rate hikes until demand drops sufficiently to take inflation – and employment - down with it.
  • The Fed does not appear overly concerned with the lagged effect of rate hikes and specifically mentioned they will accept a sustained period of below-trend growth. Already these effects can be seen in a substantial contributor to GDP - the U.S. housing market – as it appears to be an early victim of these sharply higher rates. Existing home sales have dropped to early COVID-19 pandemic lows, as 30y mortgage rates have climbed more than 100% higher YTD to 6.25%.
  • Chairman Powell actually acknowledged housing weakness in his press conference, saying that the housing market probably has to go through a correction. More economic sectors will likely follow housing going into 2023. Indeed, just today one extremely large technology firm announced plans to cut costs in the coming months by as much as 10%. While it is just one company, others in numerous industries have already made similar announcements to varying degrees, and it’s likely that more will be doing the same in the months that follow.
  • Accordingly, this past Sunday we raised our RECESSION expectations to 70%, while RESILIENT is now 20% and ROBUST is 10%. The Fed likely will need to see some combination of decreasing inflation, increasing unemployment and sharp deceleration in other economic indicators (what the Fed calls sub-trend growth) before it pauses in raising rates towards the new terminal rate.
  • Despite the increasing risk of recession, we continue to suggest that investors seek some selective portfolio exposure to credit. We had expected that credit would widen into the Fed’s tightening cycle and adjusted the Global Investment Committee (GIC) portfolio asset allocation accordingly by sharply reducing our exposure to highly leveraged borrowers.
  • However, in addition to investment grade there may be opportunities in higher-yielding credit such as investment grade preferred securities and diversified emerging market credit. While yields and credit spreads may yet move somewhat higher, in our view investors should consider these higher yields offered by quality credits as a potential opportunity to obtain longer term core income for their portfolio.

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