Carmignac: Will the Fed manage to avoid a significant tantrum?
Carmignac: Will the Fed manage to avoid a significant tantrum?
By Gergely Majoros, a member of the Investment Committee at Carmignac
The Fed is facing a situation where significant action is needed! Inflation expectations keep moving higher and economic indicators, especially on the demand side, are not cooling down meaningfully.
Thus, the main question for investors ahead of this week’s meeting is “how much will the Fed care about recession risks and market volatility when its priority seems to be the fight against inflation?
Following the surprisingly high inflation data for May, the odds of a 0.75% rate hike have increased materially. The market pricing has integrated almost 2% of expected rate hikes for the next three meetings alone, namely two hikes of 0.75% and one 0.5% hike thereafter. In our view, however, there is still a strong case for a 0.5% hike this week’s as 0.75% would probably “add to” and not “reduce” the current uncertainty and volatility in the rate markets. This would of course not prevent the Fed from implementing 0.75% hikes later on.
At the same time, the Fed is expected to shift its inflation policy into restrictive territory. So far, the framework is that the Fed aims to bring policy rates expeditiously back to “neutral” (2.5% according to the Survey of Economic Projections), whereas the market terminal rate has moved further upwards to almost 4% today.
As such, the Fed has essentially two strategies. It can either decide to go stronger this week, i.e. scare the markets first and then repair the damage thereafter, if needed, or it can decide to go softer today but put all available options on the table for the foreseeable future, in a similar approach to that seen at February’s meeting.
In this context, investors are facing an increasing dilemma. On the one hand, the large amount of tightening already expected has started to bring bond yields to attractive territories. For instance, the 10-year Treasury yield has reached 3.3%. Subtracting inflation expectations of around 2.7% (10-year break-even), this translates to a positive real yield of some 0.6%. On the other hand, the visibility on inflation dynamics going forward and thus on the future Fed hawkishness, is still very low.
The current extreme volatility in rate markets may prevent many investors from starting to enter a long exposure in the US Treasury markets. Given the significant amount of tightening already priced, which should in turn also continue to add to the likelihood of a US recession in 2023, rate markets have certainly moved much closer to their inflection point, in our view.
In the face of such uncertainty, one thing everyone can agree on is that the remarkable come-back of inflation will make the job of the Fed, and Fed watchers, much more challenging than it has been for the last 10 years.