Markets to Fed: Slow Down, You Move Too Fast
The Federal Reserve continues to promise it will keep up the race against inflation until it crosses the finish line by bringing core inflation down to 2%. Based on the most recent estimates in its Summary of Economic Projections, the Fed sees the federal funds rate moving up to the 4.5% to 4.75% range by early 2023. Fed Chair Jerome Powell has even acknowledged that there may be pain involved—perhaps a mild recession—akin to a "fender bender" that causes some dents in the economy but doesn't total it.
However, in recent weeks the possibility of a more serious accident has emerged—the risk that the Fed's aggressive tightening will not just tip the U.S. into recession, but potentially de-stabilize the financial system in the process. Volatility has spiked up in a range of markets from currencies to bonds, raising concerns about the ability of the global economy to cope with sharply higher U.S. interest rates. If these trends continue, the Fed may end up moderating its pace of tightening and slow the pace of its quantitative tightening program, which is reducing the Fed's balance sheet holdings.
It's not about a pivot or a pause—it's about pace
Note, that doesn't mean we are suggesting that the Fed will stop tightening or cut rates this year or early next year. Rather our view is that if financial stress continues to rise, it may shift to smaller rate hikes.
The Fed was late to start tightening, allowing inflation to rise, but has made up for lost time since its initial rate hike in March 2022. The federal funds rate has moved up by 300 basis points1 at an accelerating pace. On a rate-of-change basis, it is the fastest rate-hiking cycle in modern history.
The pace of Fed rate hikes in this cycle, in comparison to previous cycles, has been rapid
Federal Funds Market Rate - Upper Bound (FDTR Index), using monthly data. Past performance is no guarantee of future results.
Note: Lines represent the cumulative change in the federal funds target rate from the start of each rate hike cycle shown.
Because monetary policy works with a lag, the impact of rate hikes is just beginning to work its way through the economy. But there's plenty of evidence that rate hikes are working. Gross domestic product growth has slowed to a crawl, led by weakness in housing and manufacturing, while the Conference Board's U.S. Leading Economic Indicators have fallen for six consecutive months. Moreover, commodity price inflation has fallen sharply from peak levels and service sector pressures are starting to ease. In fact, there's a good chance that the economy has already entered a recession. None of this is surprising. It's part of the Fed's plan to slow down the demand side of the economy to quell inflation.
Conference Board U.S. Leading Economic Index has fallen for six consecutive months
Conference Board U.S. Leading Economic Index Month Over Month (LEI CHNG Index). Monthly data as of 8/31/2022.
Note: Leading indicators include economic variables that tend to move before changes in the overall economy. These indicators give a sense of the future state of an economy.
The troubling development in recent weeks is the spike in volatility across many financial markets. The dollar has surged to new all-time highs on a trade-weighted basis, driven by a combination of relatively high U.S. yields and demand for perceived safe haven assets amid global political turmoil.
A strong dollar helps hold down U.S. inflation by making imports less expensive, because each dollar can buy more goods, and it slows growth by making U.S. exports less competitive. In that way, the dollar tends to "export inflation" to trading partners.
Bloomberg U.S. Dollar Index
Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 12 p.m. Eastern Time 10/7/2022. Past performance is no guarantee of future results.
However, there are potential negative effects that could spill back on the U.S. economy. Foreign central banks have had to hike interest rates to stabilize their currencies and inflation, which usually involves selling U.S. Treasuries. Even the Bank of Japan, which has welcomed higher inflation, intervened in the market to support the yen recently because it had fallen so rapidly. It was the first such intervention since 1998.
Moreover, since the dollar is the world's reserve currency and is used in the majority of global transactions, a rapid rise can increase the cost of borrowing globally, especially in emerging market countries where companies and countries have borrowed heavily in U.S. dollars. Servicing those loans or repaying the debt with a currency that has fallen raises the risk of defaults.
Stress is also showing up in the Treasury market. Volatility has risen to levels previously seen during periods where financial institutions have had trouble transacting easily. The last episode was in pandemic period in March 2020, which resulted in the Fed stepping in to provide more reserves to the system. Consequently, the risk premium demanded by financial institutions and investors in the fixed income markets is rising.
Treasury market volatility nearing the March 2020 high
Merrill Option Volatility Estimate (MOVE INDEX). Daily data as of 12 p.m. Eastern Time 10/7/2022.
Notes: Merrill Option Volatility Estimate (MOVE) is a yield-curve-weighted index of the normalized implied volatility on 1-month Treasury options.*2022 YTD average as of 10/5/2022.
Past performance is no guarantee of future results.
Currently, measures of global financial stress have risen even more sharply than in the U.S. Periods of high financial stress reflect high volatility and increasing costs for institutions or businesses to obtain funding in the markets.
Financial stress is rising
Office of Financial Research (OFR) Financial Stress Index Total: Global (RFSITOTL Index) and Office of Financial Research Financial Stress Index Total: U.S. (RFSIUS Index). Daily data as of 12 p.m. Eastern Time 10/7/2022.
Slower pace ahead?
While we don't expect the Fed to stop hiking rates, we believe a good case can be made that market pressures may force it to slow the pace. In slamming on the monetary policy brakes, the Fed has laid the groundwork for lower inflation, but also raised the potential for global financial market stress to derail economic growth.
What should investors do?
During times of high market volatility, we suggest investors focus on holding high-quality bonds—such as Treasuries, investment-grade corporate bonds, and investment-grade municipal bonds—and minimizing exposure to riskier segments of the markets, such as high-yield and emerging- market bonds, until there are signs that the Fed is ready to slow down its pace of rate hikes.
1A basis point is 1/100th of one percentage point, or 0.01%.