Interest Rate Update - Both Your Friend & Your Foe
The recent talks by all the US Federal Reserve officials are all aimed at ramping up the market's expectations on interest rates further. And it ended with the grand finale from Jerome Powell yesterday.
"It is appropriate in my view to be moving a little more quickly" ,"I also think there is something to be said for front-end loading any accommodation one thinks is appropriate. ... I would say 50 basis points will be on the table for the May meeting"
Based on the calendar, this is their last scheduled talk until the next FOMC on 3-4 May 2022. It is part of the Fed's job to provide the market with forward guidance. And I would say they have been very careful in gradually releasing information they want the markets to disseminate.
At the start of the year, people are talking about the number of 0.25% hikes this year. But now, it is more appropriate to look at 0.5% hikes instead.
Where Is The Fed Funds Rate Going Now?
Based on the latest information, the market baked in a full 0.5% hike for the May and June FOMCs. In fact, a significant number of participants are betting on a 0.75% hike in June. For July And September, the expectations also leaned towards a 0.5% hike or more. And at the end of the year, we might be looking at a Fed Funds Rate between 2.75% and 3.00%.
This is several notches higher since the last FOMC in March 2022.
How Is The Yield Curve Looking Now?
Given all these developments, the US Treasury yield curve shifted a fair bit. We started 2022 with an upward sloping curve at lower yields. Since then, the entire curve shifted steadily upwards as rates expectations moved up. But there is a distinct flattening on the longer ends of the curve from the 2Y to 10Y. And at one point, the yield curve even went slightly inverted if we look at the 2Y and 10Y yields. This means the 10Y yield is lower than the 2Y yield and this typically does not occur in a healthy economy. But that said, the inversion happens only very briefly over 2 days. Whether the duration of inversion is of any significance, there is no conclusive study. But after Fed announces the trimming of its balance sheet, the long end of the curve did start to steepen back.
The Current Market At A Glance
It is an exceptionally tough year for most. Most asset classes are down. Stocks, the main favorite among retail investors, are hit as well. If you are into growth and aggressive stocks, it will be worse. But if you are into value and more defensive stocks, then you should still be doing alright at the moment. Bonds bore the bulk of the brunt from the dual headwinds - inflation and rising interest rates. And government bonds fared worse than others. The only shining beacons here are Gold and Commodities. Gold was often regarded as a hedge against inflation. While it did respond, it wasn't as much as expected. Commodities are the big winner here because this asset is an inflation driver.
The US Fed made their intentions clear to tame inflation. It seems the logical choice. If you put yourself in their shoes, the urgent task on hand is to put out the immediate fire stoked by runaway prices before it goes further out of control. Yes, there is a price to pay for that as harsh measures can tilt the economy toward a recession. But that will be something to worry about further down the road. And according to Jerome Powell, they are ready to slow the economy down but they will try to avoid a recession. I mean how else do you expect inflation to come down? Fed's key weapon against inflation is interest rates and it is a blunt tool that goes about whacking everything in its path.
So now, the first part about slowing down is pretty much a certainty. But the last part about avoiding a recession is a question mark. If anything, you can be sure the market will respond before Fed.