The strong case for 50 basis point hikes
Jamieson Coote Bonds expects the Federal Open Market Committee (FOMC) to hike by 50 basis points to begin their hiking cycle at the March FOMC meeting on March 17th 2022. This is an aggressive opening to policy withdrawal, and will be the first stage in large reversals of accommodative policies over 2022 which will impact every asset class.
If the U.S. Fed only hikes by 25 basis points, financial conditions will actually ease, the exact opposite of what they are trying to achieve in taming inflation. The market is currently pricing in a 45 basis point move at the March FOMC meeting, delivering only a 25 basis point hike is actually dangerous and risks instability later in the year.
Looking back to the late 1990s, huge equity valuations of tech stocks (sound familiar?) and higher inflation (around 3.5% at the time) put the U.S. Fed on a hiking cycle. In early 2000, the U.S. Fed hiked twice by only 25 basis points when markets were expecting a better chance of a 50 basis point move at those meetings (Jan and Feb 2000), before then needing to slam on the brakes, and hike by 50 basis points in May 2000, adding to the pain of the tech wreck. The unforeseen disaster of the September 11th terrorist attacks saw the U.S. Fed Funds rate cut aggressively later in the year.
To start the hiking cycle with a 50 basis points move is very rare, as the typical path for the U.S. Fed Funds rate is a profile that mimics escalators and elevators. That is, when the FOMC raises rates, they will go up the escalator, usually hiking slowly in 25 basis point increments, rising to reach a crescendo over time, before markets perceive they’ve gone just that little bit too far.
Higher funding rates tighten financial conditions and usually cause a feedback loop that sees cracks in the risky asset spectrum, causing the FOMC to cut rates aggressively as they come back down the elevator. In the last hiking, the U.S. Fed hiked rates just once in 2015, once 2016, three times in 2017, and four times in 2018, with the crescendo being the freezing of corporate credits markets in November 2018. This resulted in a near 20% drawdown in equities in December 2018 and led the U.S. Fed to cut rates by July 2019. We have seen these cycles play out time and time again in 'normal' environments. We are not in normal times however, as the U.S. Fed has fallen dangerously behind the curve.
The most recent Consumer Price Index (CPI) data in the U.S. showed a year-on-year increase in prices of 7.5%. This was higher than the market expected, and is proving to be a serious challenge for the U.S. Fed, who only a few months ago were convinced that the increase in CPI was 'transitory'. The U.S. Fed has pivoted away from such terminology around inflation as food, energy, rent and used cars continue to be the main sources of higher prices. Throw in COVID-19 induced supply chain challenges, and the case for inflation being sticky at heightened levels for a more period is proving a headache for not only central bankers, but both Main Street and Wall Street.
To address this and deliver on its inflation mandate, the U.S. Fed has missed the opportunity to dampen inflation via tradition channels with an orderly response, as the difference between CPI and U.S. Fed Funds has now reached its highest levels in 50 years. The U.S. Fed must now aggressively destroy demand to curtail runaway inflation.
Figure 1. Difference between CPI and Fed Funds Rate
We continue to expect 2022 will remain a highly volatile year for all asset classes as the removal of Quantitative Easing, the hiking of interest rates and the coming decline in fiscal spending (the fiscal cliff) are all individually big stories within the market. All three policy changes combined in 2022 will adjust the policy landscape significantly.
Strengthen your portfolio with global high-grade bonds
Jamieson Coote Bonds (JCB) is a specialist investment manager of domestic and global high grade bonds including a global absolute return strategy. Stay up to date with our latest insights by following us on LinkedIn, or visit our website for more information.
MORE ON Fixed Income
Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...