The prevailing bias among market participants over the past few months has been that an early start to rate hikes would imply a need for less tightening overall. Put another way, more now equals less later. From our perch, while there was a lot of hawkish jawboning by Jay Powell in the communication today, the shift in the Fed’s projections really just aligned with what the Eurodollar market was pricing. The 2022 median rate expectations from the Committee increased to three rate hikes next year, more than economists had expected. However, the 2024 dot plot showed only two rate hikes, leaving the overall magnitude of the policy cycle at 2.125% or very close to the consensus beliefs of the sell-side economics community.
Investors had bought protection or reduced exposure to low rate-liquidity beneficiaries ahead of the December meeting. That likely explains the relief rally in those assets when the Fed was less hawkish than feared. Looking forward the market is still facing a faster withdrawal of super-abundant liquidity (taper of the asset purchase program) and a rise in the discount rate. The taper of QE is running at twice the pace of the previous episode, asset valuations are considerably more elevated and growth is already starting to decelerate (albeit from a robust pace).
While the median projection for the Fed Funds rate at the end of 2022 moved up to 0.875%, a full hike more than expected, the prevailing bias of the Committee appears consistent with the markets that this will start to moderate inflation pressure. The 2023 PCE median forecast only moved up slightly and 2024 was unchanged. More tightening now (or next year) means less later. Hence the moderation in 2024 median funds rate projections.
We would probably not have a quarrel with that observation for next year, however the balance of risk is probably tilted to even faster policy normalisation given strength in the labour market and persistent inflation pressure. Who knows how the world will look in 2024, but consensus beliefs of the committee and the markets still appear anchored on a moderate cycle and a terminal (neutral) funds rate of less than 2.5%. The potential risk of a tantrum and volatility episode might occur if there was a shift in the markets view on the terminal rate because of the threat of more persistent inflation.
As we have also noted recently, it is plausible that tapering of QE is a form of tightening. The Fed’s Wu-Xia Shadow Funds rate (adjusting for the impact of QE on rates) is starting from -1.8%. The reversal of QE is approximately equal to 7 rate hikes before the Fed even lifts the policy rate next year (chart 1). That is probably why the 2018 cycle appeared to be more impactful on risk assets.
On the positive side for markets, equity returns tend to be positive in the months leading up to and following the first Fed rate hike. The real damage from higher rates tends to occur later in the cycle when tighter policy flattens or inverts the yield curve. Of course, that’s why we have highlighted the potential risk of a faster-than-expected withdrawal of liquidity. Moreover, asset valuations are considerably more elevated (the S&P500 is trading well above 2000 levels on a price to sales multiple – chart 2) and growth has already started to decelerate (chart 3).
In conclusion, seasonality and the fact that the Fed was probably less hawkish-than-feared will likely support equities in the near term. However, the quantum of the rally might be constrained by the major headwind; the end of super-abundant liquidity. The good news for Asia is that valuations, positioning and beliefs are starting from a much less euphoric level. China has also started to ease liquidity and credit. Of course, a more rapid withdrawal of dollar liquidity (and US dollar strength) would also remain a headwind for emerging markets. We are positioned net long equity and credit into year end.