At its June meeting, the US Federal Reserve's Federal Open Market Committee (FOMC) raised the US interest rate by 75bps (1.50%-1.75%). This was the first time since 1994 that the FOMC has raised the rate by 75bps in one go. Investors may potentially view the development as an opportunity to obtain longer term core income for their portfolio via quality fixed income exposure.
- The Federal Reserve’s other policy rates such as the IOER (paid to banks for reserves) and the RRP rate (paid to funds for overnight deposits) were also raised to 1.65% and 1.55% respectively.
quantitative tighteningprogram also began this month. The Fed did not give many additional details on expected balance sheet reduction, other than the cap of $47.5 billion per month stepping up to $95 billion per month by September.
dot plot, or the 18 committee members’ current expectation for future rate hikes (it is not a
committee forecast), was adjusted much higher and now implies almost seven additional rate hikes by the end of 2022 (median 3.40%) and roughly 1 1/2 additional rate hikes in 2023 (median 3.75%).
- Notably, many participants indicated a slightly higher rate for 2023 of around 4%. 2024 actually shows rate cuts down to 3.375%, and
longer termthe Fed Funds rate actually drops to 2.50%. The initial Eurodollar market reaction for 2022 was muted, with the market having already priced eight additional rate hikes in 2022, but 2023 futures eased rate hike expectations slightly. Of note is that the
dot plotindicates a slightly longer time frame to reach
neutral, and a lower level just below 4%, than what the market had been pricing.
- The Fed adjusted 2022 projected median Core PCE inflation up from 4.1% to 4.3%, while 2023 was adjusted higher from 2.6% to 2.7%. Risk is to the upside on inflation. Of note, the FOMC repeated its comments that
nflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.The Committee also referenced the Ukraine conflict again stating that
the inflation and related events are creating additional upward pressure on inflation.
- The FOMC statement also stated that it was
strongly committed to returning inflation to its 2% objective, perhaps to underscore the seriousness of the Fed’s commitment in fighting inflation.
- Fed Chairman Jerome Powell noted in his press conference after that:
the pace of rate hikes will depend on incoming data. Powell also said that a 50 or 75-basis point move was most likely at the next meeting in July, and that he would like to see policy rates
modestly restrictiveat the end of this year at 3-3.5%.
- In reference to the 75bp hike the FOMC just made, Powell stated that
When I offered guidance at the last meeting, I said it was subject to the economy performing about as expected. We got the CPI data and data on inflation expectations late last week and we thought while this is the appropriate thing to do. Do you wait six weeks? That's not where we are. So we decided to go ahead.
- Just last year, Powell noted that lags in the timing of monetary policy’s peak impact means that monetary easing or tightening can come at a time after when the need has passed. While we don’t believe policy easing should have continued (QE just ended in March), a pro-cyclical US monetary policy is now a risk looking forward given the large build-up of monetary and fiscal restraint.
- By raising rates this quickly, while the Fed may achieve its goal of reducing inflation somewhat by pushing down demand, it may also perversely prolong a higher price environment for longer due to both adding to company costs and leading to firms’ underinvestment.
- While the Fed may be trying to lower demand and therefore prices even if this risks a recession, this drop in demand may simply result in a corresponding drop in supply.
- This combination of more ingrained long-lasting cost pressures and declining production is the essence of why stagflation is so pernicious and destructive. The Fed clearly needed to raise rates and tighten monetary policy, but it would be more prudent in our view to do so more gradually. Given the Fed’s history of easing – and now using QE – in recessions, the Fed should consider a policy tightening trajectory that it can sustain.
- We should note here again, as we have many times before, that dislocations in credit caused by
contagionare often potential opportunities for investors, and so we continue to suggest some portfolio exposure to credit. We had expected that credit would widen into the Fed’s tightening cycle and adjusted our portfolio asset allocation accordingly by remaining underweight in HY, as well as seeking credit hedges.
- While inflation is expected to remain high in the near term and yields and credit spreads may yet move somewhat higher, in our view investors should consider these higher yields offered by quality credits as an opportunity to obtain longer term core income for their portfolio.