Fed rate increase contributes to headwinds

Introduction

The Fed began its hiking cycle yesterday by raising the fed funds rate by 25bps. Moreover, they forecast another six rates for 2022. The dot plot confirms the aggressive expectations of hikes:

Source:Summary of Economic Projections - March 16, 2022

The median forecasts to 2024 are as follows:
- 2022 – 1.9%
- 2023/2024 – 2.9% (peak)
- Longer-term – Moderation

An argument is that the Fed has been behind the curve and contributed to the high inflation rate of 7.9%. However, given the geopolitical concerns, a 50bps hike may have added to the current uncertainty, with the Fed settling on 25bps. We note that St Louis Fed President James Bullard dissented, wanting a 50bps increase. The statement also stated that the "[c]ommittee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting" (policy statement). This reduction of liquidity may begin in May and is considered a further contribution to tighter policy.

Lower GDP but higher inflation forecast

The Fed has significantly lowered its GDP growth forecast for 2022 since it released its last projections in December. The change in real GDP is at 2.8% this year instead of the previous 4%. The forecasts for 2023 and 2024 remain unadjusted.

The FOMC statement acknowledges the human and economic toll of the Russian invasion of Ukraine. It states, "[t]he invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity" (policy statement).

Significantly, the core PCE inflation is adjusted higher for 2022 at 4.1% (December's forecast was 2.7%). The Fed also changed 2023 and 2024's numbers to 2.6% (2.3%) and 2.3% (2.1%), respectively.

Investor required rate of return is in flux

Given the time value of money characteristics inherent in the financial markets, the rate hike and the associated geopolitical risk premium are currently in flux. To this end, investor required rate of return (r) has likely increased. Moreover, given the aggressive nature of the Fed's hiking schedule, the odds favour that r will expand even further. This amplification is likely to strengthen headwinds acting against the present value of risky securities.

The flattening yield curve

Below is the 10-2 yield curve. The 25bps hike has pushed it closer to inversion. The current spread between is only 22bps. It is making provision for higher rates on the short end; however, the longer-term note is a worry. Market participants are not rotating capital out of bonds at a pace that will steepen the curve. This lack of action suggests that the rate of return as above may only be attractive at lower risk market prices. As such, investors are content to keep their fixed income longs. I.e., the current expectations and outlook over the longer term are not optimistic.

Source: www.tradingview.com

Conclusion

In its release, the Fed was hawkish, which is likely to create pressure on present values as r adjusts. However, it may support the greenback, especially if future meetings provide increased hawkishness and further upward revisions.