The US Fed – 75bps Hike as Expected

As expected, the US Fed raised the funds target range by 75bps, making it a cumulative 225bps rate hike in 2022. The target range for the federal funds rate is currently at 2.25%–2.50%

The Fed’s statement acknowledged that the "recent indicators of spending and production have softened", but that "job gains have been robust". It is still "highly attentive to inflation risks" and expect the "ongoing increases in the target rate will be appropriate". The Fed will continue to run down the balance sheet and remain "strongly committed" to bring inflation back to its 2% target.

We believe the Fed's work is not over. It would be digesting two jobs and inflation reports plus the Fed’s Jackson Hole symposium (August 25–27) before the 21 Sep FOMC meeting. Jackson Hole is when we will get a clearer indication from the Fed.

In our view, there are many possibilities. Hence it is not a surprise for the Fed to be somewhat “vague” in its forward guidance. The Fed chair’s comment on the size of future rate hikes will depend on data and smaller rate hikes will be appropriate at some point make obvious sense.

We expect a 50bps hike by the Fed in September and 25bps or 50bps in the November FOMC meetings and much will depend on the data with a final 25bps hike in December. This would mean another 100bps–125bps by the end of 2022 to normalise at 3.25%– 3.50%.

Our 2023 Narrative Is a Rate Cut by the Fed

By front-loading the policy rate hike aggressively in response to high inflation, there is clearly the fear of a recession. Household finances are already being squeezed by inflation and confidence if the housing market drops after a 40% price appreciation over the past two years. And the dollar strengthening and widening credit spreads are additional headwinds for the economy.

During recession, inflation is set to fall fast. Falling house prices would hurt rentals in 2023. We expect supply chains to improve in 2023 and will address the mismatch between supply and demand. Softer demand will reduce corporate pricing power, lower imports, ease producer price inflation with moderate wage growth. Gasoline prices should also drop gradually. All these point to a dampened inflationary environment. We expect inflation to drop to 1.9% by the end of next year.

Now looking at the Fed’s past track record, high interest rates are there only for a short while. If we look at the 50-year pattern, the average period between the Fed rate hike cycle and the first rate cut is about six months. We reiterate our rate cut view in the 2H23.

Minimal reaction in markets

Markets saw minimal reaction to the 75bps hike. Only the inflation breakevens were slightly higher. Nominal rates are seeing little change. But the 75bps hike has calmed inflation expectations.

So we think market rates have peaked, especially the 10Y Treasury yield in mid-June when it reached the 3.5% region. And the 5Y is now signalling a turn in the cycle. It is between the 2Y and 10Y and is trading cheap and rich.

The expected 75bps hike by the Fed suggests that inflation remains a concern. And we feel the Fed has completed more than 60% of its rate hikes. With the hikes expected to remain but at a slower pace, we foresee the US yield curve coming under a flattening pressure. The 2-year inflation breakeven is now around 3% from around 4.5% in mid-June and 5% in March. We believe the next big move will be a steepening in the front end. The curve will begin to get ready for potential cuts at some point in 2023.

Dollar Reaction Is Negative

Although the dollar reaction is negative from the 75bps hike, such reaction will not last long. We expect a correction to take place. The dollar rally prior to the meeting and the correction post-FOMC is our base case view.

Still, the dollar is expected to stay strong due to: (1) the Fed’s still hawkish stance and that will continue to strengthen the dollar at least into September; (2) instability in risky assets; and (3) geopolitical risks for the European region due to the Russian gas crunch. We expect the dollar to remain as the safe-haven currency and should retain some strength. On that note, there is still upside risk for the USD/MYR to reach the 4.50 levels between now and September. We maintain a 25bps hike by BNM in the September MPC meeting.

Source: AmInvest Research - 28 Jul 2022