January 21, 2022
- Markets are pricing in a much more aggressive Fed
- Yield curve will be closely monitored by the Fed
- Rate hikes don’t abruptly halt the expansion or bull market
Who? Chairman Powell. What? The January Federal Open Market Committee Meeting. When? Next Tuesday and Wednesday, January 25-26. Where? Washington, DC. Why? To review economic and financial conditions and determine next steps for monetary policy. These questions cover the basics, but investors want to know the details behind the Fed’s economic assessment and how policy will be adjusted. We don’t anticipate any rate hike action next week, but we do expect answers on how the Fed plans to unwind its ultra-accommodative stance, which we assume will start with a rate hike at the March FOMC Meeting (March 15-16). Below we analyze the market’s expectations relative to historical precedent and versus our views, and discuss the implications of Fed tightening on the economy and equity market.
- What Action Will The Fed Take? | Next week, the Fed is expected to provide commentary regarding the projected rate hike path and the outlook for the unwinding of its record-level balance sheet. But as for what may be released, it depends who you ask:
- If You Ask The Market | Following a hawkish pivot from the Fed at the September FOMC meeting, the market is pricing in a significantly more aggressive Fed. According to fed funds futures, the market is pricing in a little over four interest rate hikes through year-end 2022 and almost seven through 2023. Before the September meeting, the market had been pricing in just one and three hikes over those time periods, respectively. And just a year prior, not even one hike was forecasted for either year! The point is that expectations can change very quickly, especially when they move to extreme levels.
- If You Ask The Historians | With varying macroeconomic backdrops and interest rate levels at the time of previous tightening cycles, it surely isn’t an apples to apples comparison. But if history proves prescient, the Fed has historically implemented an average of ~5 interest rate hikes in the first 12 months of each cycle over the last 40 years. There is an outside chance that could happen this time, but our contrarian view is really with the magnitude of increases after the first year.
- If You Ask Us | Our economist foresees three to four interest rate hikes in 2022, all of which the economy should be able to absorb. However, if the economic conditions move closer in line to the Fed’s forecasts—specifically decelerating inflation and a modest slowdown in economic growth—it will grant the committee flexibility and 2023 hikes could be limited to two. A few more reasons we believe the Fed will be less aggressive than market expectations in this tightening cycle include:
- Balance Sheet Wind Down No Longer A Question | At a run-off rate of $75 billion per month (equivalent to $900 billion per year) beginning in the second half of the year, the unwinding of the balance sheet could be equivalent to ~2 hikes.
- Want To Keep Yield Curve Inversion Out Of The Question | Since 1985, the start of tightening cycles (excludes mid-cycle hikes such as 1999) has seen the spread between the 10-year and 2-year Treasury yield average 150 basis points (120 basis points was the low). At 85 basis points, this would be the narrowest spread on record at the time of the first rate hike, suggesting that the Fed may not have as much flexibility in the degree of rate increases. More important, an inverted yield curve often precedes a recession—an outcome the Fed would like to avert given the early stage of this expansion.
- Trends Call Magnitude Of Hikes Into Question | From a historical perspective, interest rates have been steadily declining over the last 40 years, and tightening cycles have ended below the previous cycle’s peak in each of the last five major tightening cycles. If this trend persists moving forward, we estimate rates would likely hit resistance around 2% for this cycle. Also note, that if the Fed increased rates by ~300 basis points (the average increase over the tightening cycles dating back to 1983), this would bring the policy rate to the highest level in nearly 15 years! At that time, cumulative debt (household, corporate, and government) was roughly half of the levels seen today. Given the increased interest rate sensitivity of the economy, a likely slowdown in the housing and automobile markets would serve as a self-correcting mechanism before rates got to this level. As a result, we expect a more muted tightening cycle relative to history.
- What Are The Market Implications? | A tightening cycle is not synonymous with the end of an economic expansion nor the end of an equity bull market. From an economic perspective, rate hikes do not immediately hamper an expansion, as history shows that the economy grows for an additional five years, on average, following the first hike. Similarly, the equity bull market historically continues for an additional 3.8 years, on average, with additional gains of another 100%! However, in the near term, expect the transition into a tightening cycle to lead to more muted returns and elevated volatility. In fact, there is typically one 5% pullback (we may have just got that!) in the 3 months preceding the first hike and another 3-4 in the 12 months that follow.
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** Source: Bloomberg.
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