THE FACTS
The US Federal reserve hikes rates by 50 basis points yesterday evening, as it was widely expected. They increased key rate to 4.5%, the highest since 2007. Projected rates would end next year at 5.1% (+50bps beyond prior median of 4.6%), according to Fed median forecast, before being cut to 4.1% in 2024 - higher level than previously indicated (see FOMC dots below). Prior to decision, markets were expecting rates would reach ~4.8% in May.
Fed dots
Source: Bloomberg
During the conference call, Fed Chairman highlighted the following key points:
We also note some hawkish revisions to the inflation forecast with a majority of FOMC participants seeing core PCE decelerating to 3.5% at the end of 2023, versus a projection of 3.1% in September.
The Fed also released its economic projections: real GDP to grow by a mere 0.5% in 2023, and by just 1.6% in 2024. It sees the unemployment rate rising to 4.6% by the end of 2023 (vs. 3.7% now), i.e the Fed sees more economic pain ahead as this is the price to pay to fight inflation.
OPINION
So overall a hawkish message which wasn’t fully bought by investors as:
In other words, the bond market isn't buying Fed hawkishness. The Fed can change the Dot Plot all they want, but at this point in the cycle the market believes there is no chance they’ll be able to keep rates above 5% for the entire 2023.
So why the Fed message wasn't taken too hawkishly? Investors think the Fed is bluffing. And that current tightness will lead to lower inflation quicker than the Fed said.
Bottom-line: The Fed remains hawkish and the statement takes back some of Powell’s perceived dovishness at his recent speech.
The clustering of dots for 2023 above 5%, with only two below that level, shows an FOMC on the same page to get the job done (at the risk of triggering a recession).
Bulls believe that falling inflation could allow the Fed to deviate from its aggressive path before it's too late - and this should trump the negative effects of downward revisions to earnings.
They might be right but there are many downside risks attached to this scenario.
In the short-term, the Fed might have to keep a hawkish communication as the easing of financial conditions (due to a less hawkish interpretation by the market) is counterproductive to what the fed intends to achieve. In the medium-term, there are two additional issues. First, the assumption that a Fed which would turn less hawkish would help increase equity valuations doesn’t take into account the fact that equity valuations are not cheap (equity risk premium currently stands at 2.5%). Second, the fact that the Fed is still pursuing quantitative tightening and not cutting rates at a time the economy might enters recession and earnings revision are being downgraded is something which hasn’t happened in the past (see table below). The key turning point in terms of monetary policy will not be a pause but rather a clear pivot (i.e rate cut). This will only take place if something breaks (the economy or the market). This means that equity volatility could stay elevated for some time.