INSIGHTS

On January 28, 2022

Hawks Prepare for Fed Liftoff

Markets may have had a tough start to the year, but the Federal Reserve (Fed) intensified its hawkish tone yesterday, guiding to policy rate "liftoff" in March and quantitative tightening to follow. Market volatility would need to be more severe than in recent weeks for it to reconsider.

Fed playing catch-up again

The Fed has potentially lost control of the narrative in recent weeks, playing catch-up to market pricing and public sentiment on inflation.

Going into this meeting, speculation was rife that the Fed would hint at hikes in consecutive meetings, or even in 50 basis point (bps — 0.01% of 1%) increments — a far cry from the December meeting where just two members projected four hikes in 2022.

Fed Chair Powell left multiple hiking paths on the table, highlighting that the Fed will be “nimble.” Powell also emphasized the Fed will be transparent to avoid surprising the market, thus potentially making it easier to execute rate hikes.

We currently expect hikes in 25bps increments every other meeting

While the path of policy can change, our base case is that the Fed will hike rates in 25bps increments every other meeting. Even though Powell refused to rule anything out, we anticipate sharp 50bps hikes to be unlikely, with the Fed preferring to leave the door open to increasing the pace of hikes if needed.

“Quantitative Tightening” is coming, but liquidity will remain abundant

In addition to its usual statement, the Fed released principles for reducing the size of its balance sheet, reaffirming that it plans to allow assets to run off its balance sheet after policy rate liftoff.

The principles state: “In the longer run, the Committee intends to hold primarily Treasury securities,” indicating that the Fed will roll off its Mortgage-Backed Security (MBS) holdings faster than its Treasury holdings.

Although Powell remained guarded as to potential timing, we expect the Fed to start this process in May or June and — as hinted at the press conference — may proceed faster than last cycle’s pace (when the Fed started reducing its balance sheet by up to $10 billion per month, gradually ramping up to $50 billion per month).

However, given the sheer size of the balance sheet following pandemic-era purchases, even at a faster $80 billion monthly pace from May (which we believe is a sensible base case), the balance sheet would remain larger as a share of GDP than its 2014 peak until late 2024 (Figure 1).

Figure 1: Quantitative tightening may have room to be more aggressive than in the past

Source: FRED, January 2022

As such, we believe we are still years away from a normal balance sheet, indicating that liquidity could be abundant by historical standards for some time yet, before potentially impacting risk markets.

The Fed is looking through risk market volatility

Although equity markets had a tough start to the year, the Fed did not see this as a reason to moderate its tone.

This also makes sense to us. Financial conditions were significantly tighter in the first quarters of 2016, 2019, and 2020, when the Fed made a significant dovish policy shift. At current levels, we do not believe we are near the threshold for the Fed to turn dovish again (Figure 2).

Figure 2: Financial conditions were far looser when the Fed previous tilted dovish

Source: Bloomberg, January 2022

When questioned, Powell stated that financial market conditions are a concern to the extent that they impact the Fed’s employment and inflation mandates. So as such, there will be a Fed put at some level, as financial markets’ prices impact the wealth effect, cost of credit, and sentiment channels. However, the strike price of this put is dynamic, and we believe present market values are meaningfully away from it.

We believe it will take more equity market weakness to make the Fed look past 7% inflation than it would 2.5% inflation (Figure 3).

Figure 3: "Sticky" CPI (Consumer Price Index) and employment trends seem to be too much for the Fed to ignore

Source: Federal Reserve, Bureau of Labor Statistics, January 2022

Liftoff for hawks

The Fed’s balancing act will be to attempt to slow inflation without harming the labor market (a so-called “soft landing”).

The Fed will likely receive support in this effort, as fiscal stimulus declines in 2022 and supply chains normalize, and we believe they can succeed in slowing inflation while the amount of excess savings should support growth. However, we believe as growth moderates, it will potentially favor certain areas of credit over equity.

CRN: 2022-0119-9719 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management. 

Please note: any forecasts or opinions expressed herein are Insight Investment's own as of January 27, 2022 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.