Three in a row

The U.S. Federal Reserve's (Fed) policy setting committee boosted its benchmark rate (fed funds rate) by 75 basis points (bps) or 0.75% on Wednesday, September 21^st. That was the third consecutive increase of such magnitude, and it brought the target range for the federal funds rate to 3.0% - 3.25%, the highest level since before the 2008 financial crisis. In the days leading up to the Fed meeting, the benchmark 10-year U.S. Treasury yield climbed past 3.5%, its highest level since 2011, while the 2-year U.S. Treasury yield which is more sensitive to Fed policy actions hit its highest level since 2007, topping 4.0%. 

The Fed has been resolute in its war on inflation and will continue to hike rates and keep them elevated for longer until inflation is undoubtedly back on track towards the 2% target or as the Fed Chairman puts it, “until the job is done”. Inflation appeared to have peaked at 9.1% in June, as measured by the year-over-year change in the US consumer price index. But has not come down as quickly as Fed officials had hoped. In August, it was still above 8%.

The Fed also released updated economic projections, giving investors a clearer picture of where policymakers expect rates to end the year and go over the medium to longer term. According to the Fed’s “dot plot”, the fed funds rate is expected to finish the year in the region of 4.4%, suggesting 125bps of additional tightening for the remainder of the year. The hiking cycle is expected to conclude in 2023 at a peak or terminal rate of 4.6% and subsequently fall to 3.9% in 2024 and 2.9% in 2025. Thereafter, the Fed expects the policy rate to further decline to 2.5% in the longer run. A quantitative tightening or liquidity removal program is also underway to reduce the Fed's monstrous $9 Trillion balance sheet which doubled during its quantitative easing or bond purchases exercise during the pandemic.

Owing to the over 400bps of expected policy rate increase in 2022, economic growth is forecast to slow appreciably to 0.2% from a near 6% pace in 2021. With a shallower pace of rate hikes in 2023, growth should improve to 1.2% in 2023, 1.7% in 2024 and at 1.8% in 2025 and beyond. 

Meanwhile, Fed officials see inflation (as measured by personal consumption expenditure) remaining “sticky” for the rest of the year and only falling to 5.4% from 6.3% in July. In 2023, however, the Fed expects inflation to decline appreciably to 2.8% and further cool down to 2.3% in 2024 and finally hitting its 2% target in 2025.

However, to sufficiently cool inflation, the Fed projects the unemployment rate rising to 4.4% by the end of next year from the current level of 3.7%. The unemployment rate is also expected to remain at 4.4% in 2024 and then decline to 4.3% in 2025 before settling at 4% in the longer run.

Outlook: The more aggressive monetary policies by major central banks have stoked fears of an impending global recession and have led to steep declines in most asset prices including bonds and stocks. With central banks firmly tightening monetary policy and global growth slowing, the macroeconomic backdrop remains challenging, thus requiring patience from investors. Markets may stay rangebound for a while but should eventually start recovering as central banks become less hawkish. Investors can however use any further pullback in asset prices as an opportunity to rebalance portfolios and add quality investments at more favourable prices.

 Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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