• A Very Hawkish 75bps

• Another 75bps in November with 50bps minimum in December

• We still favour rate cuts as a theme for 2023

• Market rates under pressure higher

• FX Markets Suggest a Dollar Play

Hawkish Tone Remains

In line with ours and market expectations, the Fed raised the policy rate by another

75bps rate although some were looking at 100bps. With September’s rate hike, the Fed’s policy rate is now at 3.00 - 3.25%.

More rate hikes are expected to come over the next two meetings in November and December. Inflation is envisaged to remain sticky. With that, the Fed’s door is left wide open for a fourth consecutive 75bps hike in November and 50 bps in December 2022. For December, we certainly cannot dismiss the possibility of a fifth 75bps hike.

Hence our baseline suggests that the Fed rates should settle at 4.25%- 4.50% while the upside is at 4.50%-4.75% by end 2022.

Rate Cuts in 2H2023

Looking ahead, the geopolitical backdrop, the China slowdown story, the potential for energy rationing in Europe, the strong dollar, and fragile-looking domestic equity and housing markets point to clear sharp slowdown or mild recession risks. A more aggressive Fed rate hike and tighter monetary conditions will only intensify the threat.

Meanwhile, there are encouraging signs on both market and household inflation expectations, and corporate price plans which suggest inflation may not be as embedded as some in the market fear.

Long- term price expectations have returned to what we might term “normal”. This suggests fears of a 1970s wage-price spiral is being misplaced. It also means there are growing confidence that the Fed will indeed get inflation down.

With the risks to growth and the potential for lower inflation, we now expect the Fed to cut rates throughout the 2H2023. We foresee four rate cuts by a total of 100bps. Fed’s decision will be data dependent. Our baseline Fed policy rate outlook for 2023 would reach 3.25% - 3.50%.

Market Rates Are Now Under Pressure

The latest move by Fed resulted to a significant impact on 2yr, which jumped to 4.1% post the rate hike, a full 10bps move.

And expectations are that it can come closer to 5% in 2023. It is supported from the messaging of the Fed who intends to maintain a tightening trajectory beyond the end of 2022 and into 2023.

Meanwhile the 10yr yield now needs to consider a path towards 4% in the coming couple of months. Past records showed the 10yr hardly trades more than 50bps through the funds rate before the Fed has peaked. A 50bps is an exception. A more normal discount would be 25bps ahead of a confirmed peak from the Fed.

Looking at the real rates, it has come under pressure as inflation expectations managed to ease post the rate hike. It is certainly a positive news from ours and the Fed's perspective. While higher are real rates will help tighten financial conditions, the easing in inflation expectations tells us that the market ultimately expects the Fed to see inflation fall.

But we are yet to witness any narratives for inflation to fall big.

The thing is the case for big falls in inflation has yet to be proven. If we are right and the Fed does in fact peak by year-end, then that fall in market rates anticipated is very back on track.

Still a Dollar Play

The Fed’s has signalled to the FX markets that it will cut growth and raise unemployment forecasts while inflation will still be higher than previous forecasts and that the policy rate could be as high as 4.60% by the end of 2023. Logically, this undermines Fed ‘pivot’ ideas.

This will see the FX market biased towards slow-down or mild recession. And such playbook will really favour the dollar over procyclical currencies.

Hence, Investors should not be in a hurry to quit the most liquid FX reserve currency – at a time of escalating war in Ukraine. And if we look at the 1980s Paul Volcker period, the Fed had to bring the US economy into recession to get inflation under control. The dollar soared during this period.

Further strength in the dollar will see trading partners respond as much as they can. The ECB is ‘attentive’ to EUR/USD weakness but is never going to be able to match the 4%+ Fed policy rates coming on their way. Unlike the US economy, the eurozone is in a negative output gap. And given the events in Ukraine, it is hard to rule out a further grind towards 0.95 over coming months.

More pressing is USD/JPY which is again closing in on 145. Japanese authorities remain close to pulling the trigger on FX intervention. And we have a BoJ meeting next in this week. No change is expected from the dovish BoJ – but a tweak to the BoJ’s 10-year JGB target (0-0.25%) and intervention would certainly catch the market unawares. We believe the USD/JPY traded volatility is too cheap.

On the USD/MYR, there is still upwards pressure on the local currency. The aggressive monetary tightening by the Fed and complemented with the ongoing external headwinds should now see the local currency trade close to 4.60 against the USD. Our initial view of the local currency retracing back towards 4.45 levels by end of 2022 could be tough. Hence, our outlook for the USD/MYR is now between 4.45-50 levels as the baseline with upside risk at 4.55-60.

Source: AmInvest Research - 22 Sept 2022