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AAM Viewpoints — 75 Basis Points & Perhaps More to Come. The Latest from the Fed.


 

2022 has been a rough year for equity and fixed income investors alike. As of 6/15/2022, the S&P 500 is down almost 23% year to date and the U.S. bond market is having one of the worst years on record with the Bloomberg U.S. Aggregate Bond Index down 11.70%. One of the main drivers of the volatility has been — and will most likely continue to be — the Federal Reserve’s sharp shift in U.S. monetary policy. Financial markets do their best to anticipate and predict the trajectory and speed of future rate hikes but many times it seems even the Fed is at a loss. At the May meeting the FOMC (Federal Open Market Committee) hiked 50bps (basis points) and Chairman Powell stated, “75 basis points isn’t on the table.” Fast forward a month and a half, and the market is pricing in a strong possibility of a 75bps hike on the heels of a higher-than-expected CPI (Consumer Price Index) print which came in at 8.6% year over year. The yield on the 2-Year Treasury Note skyrocketed from a 2.85% to a 3.44% in only four trading days, Fed Funds futures contracts priced in the potential for 75bps and the spread between the 2-Year Treasury Note and the Fed Funds rate widened to the highest level in over 10 years, all implying markets felt that a bigger hike was necessary if the Fed expected to get inflation under control.

Last Wednesday ultimately marked the first 75bps rate hike by the Federal Reserve since 1994. Although stating, “I do not expect moves of this size to be common,” Chairman Powell left the committee some options for the July meeting, mentioning that 50 or 75bps moves are both viable options. This was likely a smart move, in our opinion, as the Fed has a long way to go to bring down inflation. Fed funds futures are once again pricing in an aggressive Fed with the Fed funds rate expected to touch 3.5% to 3.75% by year end. To get a better idea on the Federal Reserve’s expectation for the future path of Fed rate hikes and to gauge the overall sentiment of the FOMC, one can look at the updated Fed dot plot released last week. Projections have been raised significantly as compared to the last release on May 16. The committee now sees a year-end Fed funds rate of 3.75%, 100bps higher than projections made back in March at the previous meeting. In addition, there seems to be a larger consensus amongst members of the FOMC as most are now more in-line with each other compared to March with the majority of members at an implied target rate of 3.625% to 3.875%.

majoris1_061722
Source: Bloomberg: Implied Fed Funds Target Rate

majoris2_061722Source: Bloomberg: Implied Fed Funds Target Rate

The U.S. is not alone in trying to rein in inflation via tighter monetary policy. Since the Fed hiked 75bps last Wednesday, the Bank of England increased rates to their highest level since 2009 with warnings of continued hikes. The National Bank of Switzerland, in a surprise move, hiked rates for the first in 15 years. Switzerland getting ahead of the European Central Bank with a 50bps hike was “quite significant,” according to Mohamed El-Erian in a CNBC interview. Internationally or domestically, we simply cannot rule out these types of moves by central banks until inflation returns to long-term averages. It has become quite clear that we are in a tightening environment, and this will likely increase the probability of interest rate volatility moving forward.

Inflation will likely dictate the path of Fed policy and perhaps markets alike moving forward. Heading into the July meeting there are a few things to keep an eye on to get a better idea of where the Fed thinks inflation, and the Fed Funds rate, may be heading. The price of oil will likely continue to play a crucial role in broad inflation trends and if prices head lower from its $123 per barrel (West Texas Intermediate) peak on June 14, that might help inflation start to normalize. Rent and shelter costs, which accounts for more than 30% of CPI, have been positively correlated to the S&P CoreLogic U.S. National Home Price Index which gets released at month-end. If the next Home Price Index reading comes in lighter and signals prices cooling, this might translate into a peak and cooling in the rent segment of CPI and help bring down broad inflation numbers. If these numbers and other pricing measures continue to come in above expectations, there could be a greater chance the FOMC once again leans into the possibility of another 75bps hike. When it comes to earnings announcements in the next couple weeks, earnings calls and commentary can provide reliable insight into the macro economy, rising costs, demand outlooks, pricing expectations in quarters to come and, most importantly, the health of the U.S. consumer.

majoris3_061722Source: Bloomberg: US CPI Urban Consumers Shelter NSA / S&P CoreLogic Case-Shiller US National Home Price Index

Regardless of if/when we see inflation peak in the near term, 2022 will most likely remain a volatile year for financial markets. Inflation, which has been subdued for decades, is likely a fixture of markets moving forward. For fixed income investors, a defensive positioning with regards to duration has the potential to provide some protection from the market volatility we have seen year to date, and we believe a laddered bond portfolio remains a tried-and-true method to potentially weather the storm. In addition to a defensive duration positioning, a bond ladder also includes reoccurring maturities which provide liquidity to allow investors to potentially take advantage of any downturn. Finally, one note that might be worth mentioning is the heightened value of active management in environments such as the one we find ourselves in today. An actively managed account of individual securities might be worth looking into as a way to remain nimble and take advantage of opportunity, but at the same time avoid potential liquidity issues associated with certain other types of investment vehicles.

 

CRN: 2022-0603-10073 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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