Fed Play – “Go Big or Go Home”

On Wednesday June 14^th the U.S. central bank (Federal Reserve aka the “Fed”) delivered its biggest rate hike since 1994. The Fed increased its benchmark rate by 75 basis points (bps) or 0.75%. The drastic action by the Fed was however not surprising. Many financial market participants expected the out-sized rate adjustment and in fact encouraged the Fed to “go big or go home” to restore its credibility in the fight against inflation which hit a fresh 40-year high in May despite earlier Fed rate hikes. Inflation as measured by the consumer price index (CPI) rose 8.6% on a yearly basis in May. In addition, data revealed that the financial position of the all-important consumer (which accounts for roughly 70% of US GDP) is weakening as retail sales dropped 0.3% in May as inflation soared. Consumer sentiment also recently hit an all-time low, increasing the urgency for the Fed to intensify monetary tightening.

With the 75bps hike, the target for the Fed’s policy rate (federal funds) has been elevated to within a range of 1.50% to 1.75% and more sizeable rate hikes are likely to occur for at least the rest of 2022. Indeed, the Fed has projected its key short-term rate to end 2022 at 3.4%, suggesting an additional 175bps in rate increases for the duration of the year. The pace of rate increases is however expected to slow considerably in 2023 as the Fed forecasts its key rate at 3.8% by year-end 2023 – a mere 40bps adjustment; while, in 2024 the rate is expected to fall by 40bps to 3.5% and further decline to settle at 2.5% in the longer run. These projections are however dependent on the U.S. economy and data progressing according to the Fed’s plan. 

What are the implications for markets and bond investing?

Observers can expect more heightened market volatility over the next few days and months as investors adjust to a faster pace of Fed tightening and as incoming data fluctuate. However, wild market gyrations should wane as the year comes to an end, and more stable market conditions should ensue and prevail in 2023 and beyond, as long as a U.S. recession is avoided. The flattening of the U.S. yield curve is also expected to continue as shorter-term yields, responding to higher Fed rates, are likely to rise faster than longer term yields– reflecting slower economic growth and lower inflation. 

Increased market volatility should however create better entry points and offer potentially higher returns for medium to long-term investors; while a flat yield curve will allow investors to shorten duration or interest rate risk without sacrificing too much in bond yield. Investing for a shorter period however increases re-investment rate risk since bond yields are expected to be lower in 2023 and beyond, provided the inflation battle is being won. So, investors may also want to consider adding longer term bonds to their portfolio to lock in relatively higher yields for a longer period.

Finally, in an environment of slowing growth, and possibly a recession, bond investors are better protected by investing in “investment grade” rated bonds than “non-investment” grade bonds.

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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