Last Wednesday, the Fed decided to raise interest rates by 75 basis points for the first time since 1994, levitating the FFR in a range of 1.5% to 1.75%. Market expectations have changed drastically following CPI inflation the previous week, with CPI inflation coming in higher than expected at 8.6% in May (vs. 8.3% exp.). Policy makers have also revised their PCE inflation forecast at 5.2% for 2022versus 4.3% in their March projections.
Powell also signaled another “big move” for the July meeting to continue the fight against inflation, with the market split between 50 basis points and 75 basis points higher. According to the Fed CME Watch Tool (Figure 1), the implied probability of a 75 basis point hike is currently 86.2% (compared to 13.8% for a 50 basis point hike).
Even though the aggressive response from U.S. policymakers is primarily aimed at easing inflationary pressures as inflation continues to accelerate globally, part of the decision was also made to create headroom for the economic downturn. , which continues to approach very rapidly.
The economic outlook is deteriorating
Since the start of the year, we have seen a series of leading economic indicators price in a significant deceleration in economic activity. For example, the OECD’s “diffusion index,” which looks at the percentage of countries with rising leading economic indicators (LEIs), incorporates a significant deceleration in business activity. Chart 2 shows that the OECD’s “diffusion” index has strongly led the 6-month global manufacturing PMI over the past 25 years and currently assesses a global PMI at 46. The latest times the PMI global manufacturer fell to 46, it was in 2001, 2008 and 2020; these periods were associated with massive sell-offs in the markets.
Financial conditions also factor in significant downward readjustments in the United States
Although the risk of recession has particularly increased in Europe after the war in Ukraine, business surveys sharply slowing prices in the medium term, the economic situation has also deteriorated sharply in the United States.
In addition to soaring 30-year mortgage rates (nearly 6%) pushing homebuilders to drastically cut prices as they are hit by both lower demand (globally) and high material and labor costs, financial conditions also factored in a significant decline in economic conditions. readjustments in activity.
Figure 3 shows that the dramatic tightening of financial conditions in the United States (YoY) factors in a further drop in the ISM manufacturing PMI (proxy of real economic activity in the United States). It is important to know that the relationship between the PMI and US real growth is not linear when the PMI falls below 50 (a move from 48 to 46 is generally associated with a greater impact on economic growth than a passage from 50 to 48, etc.).
What happened to the “Fed Reaction Function”?
With rising global inflationary pressures since the start of the year, exacerbated by the war in Ukraine, and a steadily deteriorating economic outlook, investors fear a “stagflationary” outcome, which has historically been the worst quadrant for the steps. The surge in inflation risk globally has made bonds vulnerable since the start of the year, and market uncertainty combined with the sharp tightening of ST rates has led to a drop in risky assets, with US equities having dropped nearly 25% from their January high.
Figure 4 shows that equity returns tend to collapse when inflation exceeds 4%; in this chart, we calculate average monthly US stock returns for different inflation brackets using Robert Shiller’s monthly data since 1871.
When inflation rises well above 4%, business uncertainty in terms of investments tends to skyrocket and the market begins to price in a sharp tightening of financial conditions, which implicitly puts investors in a difficult position, as most assets in the financial markets tend to experience selling pressure.
So, with stock markets down 25% year-to-date, investors are wondering if the Fed will eventually “put” an implicit floor on risky assets to prevent a further deceleration in economic activity. . The last time we saw sharp stock market declines was in Q4 2018 and Q1 2020, which were immediately offset by a strong “dovish” reaction from the Fed.
We believe this time around is different due to the current level of inflation, and we expect the Fed to maintain its “hawkish” stance in the short to medium term by initiating a series of aggressive hikes, aimed at reining in inflation from year to year. end of 2023, then immediately start cutting rates as economic activity is likely to be in recession within the next 12-18 months.
Further aggressive rate hikes are likely to invert the 2Y10Y yield curve before seeing the marked “steepening” that occurs during economic downturns (Figure 5)
The US dollar will hit new highs
We still expect the US Dollar to outperform in the current environment, taking each consolidation as an opportunity to buy the dip in the DXY (UUP). Even though the US dollar looks expensive (the DXY index trading at a 20-year high), market uncertainty, the hawkish Fed, and the “stagflationary” outlook will make the dollar more “safe”.
In addition, further yield curve flattening could also support the USD in the short term; Figure 6 shows that periods of significant declines in the 2Y10Y yield curve have been associated with USD strength (and vice versa).
Long US Dollar against EUR, GBP
The rising risk of recession between the euro zone and the United States will continue to weigh on the single currency, with the EURUSD expected to reach parity this year. Additionally, risk aversion sentiment will also weigh on the British pound, which has historically been the worst performing currency in a high volatility regime. Figure 7 shows the average monthly performance of the most liquid currencies against the dollar when the VIX exceeds 20 over the past 30 years.
To conclude, the Fed should maintain its “hawkish” position in the short term in order to create additional headroom for the next economic downturn (H2 2023/early 2024), leaving risky assets vulnerable and thus pushing the preference for the US dollar.