Overview
What happened?
As widely expected, the Federal Reserve raised interest rates by another 75 basis points in July in what is now the most aggressive sequence of hikes since Paul Volcker was in charge at the US central bank in the early 1980s. Much higher-than-expected inflation remains the key driver here together with ongoing strength in the labour market. At the press conference, Chair Powell kept the option of another 75 bps on the table but caveated it by highlighting the importance of short-term data. Powell also said the Fed is now in meeting-to-meeting mode with less focus on specific guidance.
Our interpretation
We are now entering the phase of the cycle where the Fed has delivered significant tightening in a very short period. The economy is sending conflicting signals with soft data in recessionary territory whilst hard data, especially on the labour market side, is still showing ongoing resilience. With inflation continuing to surprise on the upside, without a visible slowdown in the job market, the risk of another 75 bps rise remains high. The Fed is looking at hard data which is lagging and may be forced into another burst of aggressive tightening. That said, there was more flexibility in Chair Powell’s comments at this meeting than had been the case over the last two meetings.
Our outlook
We have been of the view that the Fed would end up hiking less than market pricing. At one point, the markets priced in a terminal rate of 4 per cent which we thought was too high. We agree with the current set-up which sees the terminal rate for this cycle at around 3.25 per cent. However, the economy is sending conflicting signals and the strength of lagging hard data on which the Fed is focused may change the near-term trajectory for rates. Our base case remains one of recession in the US over the next six months given the tightening in financial conditions and slump in consumer confidence.
Asset allocation implications
We remain cautious on equity and credit with a positive view on duration given the rising risk of a severe slowdown in growth as a result of the front-loaded Fed tightening.
