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At the May Federal Open Market Committee (FOMC) meeting, the Fed delivered the widely expected 50 basis point hike (the first of that magnitude since 2000) and announced the details of the quantitative tightening (QT) program. Chair Powell's commentary centred on the inflation risks but also showed a renewed focus on the state of the labour market and the ongoing strength and its linkages with the wage inflation spiral. Crucially, Chair Powell ruled out a 75bp hike for now, thus containing the hawkishness which has been building in recent months.
We continue to think that, ex-post, the Fed will deliver less tightening than priced in by markets. Yesterday's meeting was the first sign that the FOMC is getting comfortable with the magnitude of financial tightening which is now in the pipeline (around 200bps since start of the year and now stronger than in what we saw in 2013 and 2018). We also think that the aggressive QT program (expected to be ramped up $95bn per month by September) is likely to be seen as a substitute to hiking at some stage.
That said, data, especially labour market data, remains key. We are watching for signs of emerging weakness in the housing market and of course developments on the inflation front to assess if the current pause in hawkishness is a temporary respite or the start of a major pivot.
Asset allocation views
We remain cautious in our tactical asset allocation risk settings given the stagflationary growth/inflation mix and the rapid change in policy settings coming from key central banks, especially the Fed. We continue to hold an overweight position in the dollar but are watching stretched positioning indicators closely.
That said, we do think that duration risk premia may need reassessment as tightness in financial conditions start to show up in data (in the form of lower growth and inflation). Overall, it is far from certain that the current aggressive tightening by the Fed can be achieved without leading to an accidental recession.
More views from the investment desk
The 50bps hike had been exceptionally well telegraphed by the Fed and should have been fully priced into markets. The risk was therefore related to any commentary around future rate intentions and the pace of balance sheet contraction.
Here there is a high degree of uncertainty. Heightened levels of inflation and tightening labour markets have put pressure on central banks to normalise policy. However, this comes against a backdrop of poor Q1 GDP data in the US and weak global growth projections. This divergence makes the job of monetary policy setters incredibly difficult and raises the risk of policy error. History has shown how difficult it is to engineer a soft landing, and the distortions caused by the pandemic make it even harder. The US, at least, is relatively well placed given high levels of private savings and strong corporate balance sheets.
What does this mean for equities? Markets do not like uncertainty, so we are likely to see volatility remain elevated. It is clear that it is no longer sufficient to blindly buy the market. It is important to be discerning and focus on companies that are best-positioned in this environment - those with strong competitive positions, pricing power, strong balance sheets and valuation support.
Following this 50bp rate hike, there are currently a further 250bp of hikes priced in for the next year. This would take the upper bound of the Fed Funds Target Rate to 3.5%. The speed by which the market has discounted Fed tightening has been quite incredible: just two months ago, the market had been pricing in a terminal Fed rate of just 2.25%.
What does this mean for fixed income? The fact that the Fed is now hiking aggressively into the early stages of a growth slowdown (which could easily morph into a recession) to supress inflation expectations means we think the top in US Treasury yields is fast approaching. With quantitative tightening due to commence on 1 June starting with balance sheet reduction of up to $47.5bn per month, moving to as much as $95bn after three months, and aggressive rate hikes on the horizon, this is likely to tighten financial conditions, and we could finally be at a point where investors feel comfortable taking duration risk again.
We have a cautious view of risk assets as a result of high inflation and the hawkish Fed, as well as weakening consumer and industrial confidence and the lockdowns in China. We are positioned underweight equities and credit as a result. Despite the growth outlook, we have a neutral view on duration due to concerns over inflation.
We have a preference for dollar assets and the Fed's continuing hawkishness should offer support to those positions. However, the dollar should also benefit from its defensive properties should sentiment deteriorate.