The Federal Reserve was somewhat more hawkish than expected at its December FOMC meeting, reflecting the Fed’s recent pivot to focus on persistently higher-than-expected inflation. Ultimately, we expect the Fed will be unable to hike the fed funds rate as high as they are currently projecting, anticipating the fed funds rate is likely to top out below 2%. Consequently, the bond market continues to weather the hawkish shift from the Fed and the economic recovery fairly well, reflecting trust in the Fed’s ability to achieve a soft landing.
As anticipated, the Fed announced a doubling of the pace of tapering after it signaled as much a few weeks earlier. But there was also a notable, wholesale upward revision to FOMC participants’ anticipated path of rate hikes, with the projected path now steeper and slightly higher by the end of the projection period than in the September outlook.
In their latest projections, none of the FOMC participants expect the fed funds rate to remain unchanged in 2022, and 10 participants now expect three rate hikes to bring the targeted range for the fed funds rate to 0.75%-1.0% by year-end. Fed officials continue to project three additional rate hikes in 2023 to 1.5%-1.75%, followed by two more hikes in 2024 to 2.0%-2.25%. Our takeaway from the meeting is that Fed officials are nervous inflation dynamics could take hold without more aggressive Fed action.
The Fed’s updated economic projections portray an economy running at full employment with attendant inflation pressures a lot sooner than anticipated after the severity of the COVID-related downturn. The unemployment rate at the end of next year is expected to drop to its pre-pandemic low of 3.5%—a bit lower than September’s estimate of 3.8%. Meanwhile, PCE inflation is projected to end 2022 at 2.6%, up notably from the Fed’s September estimate of 2.2%.
Our own projections are modestly lower than the Fed’s updated view: we anticipate two rate hikes next year if inflation decelerates sequentially in coming quarters as projected. This would require the current torrid demand conditions to come off the boil and supply chain problems to improve. Ultimately, we also expect the Fed will be unable to hike the fed funds rate as high over this cycle as they are currently projecting, anticipating the fed funds rate is likely to top out below 2%. Powell himself recounted the Fed’s U-turn in the years just before the COVID crisis when it became clear the Fed had tightened too aggressively in that cycle.
Until today’s meeting, the Fed was lagging a number of developed market central banks that were further along in ending their QE and in signaling a beginning of their rate liftoffs. But the Fed’s pivot and its new, more hawkish forward-policy guidance now places it in the middle- to front-half of the pack.
Sell the Rumor, Buy the News
Given that the Fed’s actions were more hawkish than expected, the market’s reaction can only be described as “sell the rumor, buy the news.” That’s certainly how it played out among the biggest post-Fed movers, i.e., stocks and credit products. Following nervous price action in the run up to the meeting, a relief rally took hold in stocks and the riskier areas of the bond and currency markets, where spreads were tighter on both investment grade and high yield corporate bonds. In emerging markets, spreads tightened on bonds, and EM currencies strengthened versus the dollar, similarly reflecting a boost in risk appetite following the FOMC meeting.
Figure 1
Risk Assets Were Unnerved by the Hawkish Implications of the Fed’s Statement and More Rapid Rate Hike Projections. However, by the Time the Press Conference Concluded, Markers Had Shifted to “Risk-On,” With Credit Spreads Tightening and EMFX Rallying vs. The U.S. Dollar.
PGIM Fixed Income and Bloomberg.
A more complicated message emerged from the Treasury market, where long-term yields rose as inflation expectations increased. Perhaps the read here is that, relative to Powell’s Q&A, the markets were expecting a harder sell from Powell on the hawkish case. Instead, his balanced, data-dependent interactions with the press suggested a less aggressive rate-hike path and, thus, more inflation in the long run relative to what was expected prior to the meeting.
Looking ahead, it’s fair to say that since spring, the bond market has weathered the hawkish shift from the Fed and the economic recovery fairly well.
Figure 2
Since the Depths of the COVID Crisis Last Spring, the Rates Markets—Have Priced in a Fair Amount of Economic Recovery and Fed Rate Hikes—Appear to Be Entering a Range Bound Phase That Could Continue for a Few Quarters Until It Becomes Clear Where Inflation and Growth Settle In the Post-COVID Recovery.
PGIM Fixed Income and Bloomberg.
Long rates appear to be past their peak while credit spreads and inflation expectations appear relatively stable, reflecting trust in the Fed’s ability to achieve a soft landing. We’d agree with that view and further suggest that, with long rates and credit spreads likely to remain relatively rangebound around current levels, the bond market should be well positioned going forward as growth and inflation slowly moderate, and the Fed continues to normalize policy.