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As expected, the Fed hiked rates by 75 basis points at its November meeting, its fourth straight jumbo hike. It did however indicate an intention to slow down the pace of hikes, starting as early as its December meeting, to account for the lagged effects of accumulated tightening to date, which remain highly uncertain. To avoid the ‘pivot mania’ of last summer, Chair Powell also indicated the possibility of a higher terminal rate - which we expect to be 5 per cent - and defended the ongoing policy stance robustly. In the press conference, Chair Powell defended the Fed's focus on mostly backward-looking data, unwilling to concede that current price and labour market pressures are all essentially rear-mirror dynamics.
The Fed continues to send an unequivocally hawkish message, with no dovish pivot in sight. For the time being, fighting inflation remains the Fed's singular point of focus as the Federal Open Market Committee's risk assessment is skewed towards fear of doing too little, rather than doing too much (the latter - in contrast - being the key market worry). The bar for changing this stance remains high, with slowing economic data unlikely to be sufficient for a dovish pivot in the next few months.
We continue to expect a US recession in 2023 as the policy tightening cycle works through the system. Indeed, our activity trackers indicate a 55 per cent chance of recession by mid-next year. What is more uncertain is the potential depth and duration of that recession, which will depend on the ability of the economy to withstand tightening, the impact of external shocks, and the policy reaction to the downturn.
We continue to watch for any signs that the Fed is switching its focus from spot inflation data (backward-looking) to forward-looking indicators. This would be the clearest indication of an imminent pivot, as some parts of the US economy, such as the housing market, are already showing signs of stress. If financial conditions tighten abruptly due to market-related stresses or financial stability concerns, we may well see a faster deceleration of the hiking pace and indeed a pause. But we are far from that right now and uncertainty remains very high given many moving parts. From a medium-term perspective, we continue to think that a US 10-year real rate above 1 per cent is unsustainable but again it will take time for related damage to come through.
Asset allocation views
In the last few weeks, we reduced our underweight to duration to reflect the fact that peak hawkishness is probably behind us. We are still underweight equities and credit, as the worsening economic conditions have not fed through to earnings yet. Within equities, we remain overweight US vs Europe ex UK and within credit we prefer investment grade to high yield. Until the Fed pivot comes firmly into sight, we expect the dollar’s strength to continue - we remain overweight the dollar against a basket of emerging market currencies.