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Fast and furious

Current and ex-FED governors have been vocal over the past week that market participants should expect a ‘fast and furious’ FED policy normalisation path. The initial March 16 hike of 25bp will be followed by a series of 50bp hikes. The market prices around a 90% probability for 50bp hikes on May 4 and June 15 FOMC meetings. In order to preserve their credibility, expect a similar stance from the July 27 and September 21 FED sessions. That would bring the US monetary policy rate at 2.25%-2.50% by the very end of the summer of 2022. What happens afterwards will depend on the pace of the inflation decline. The complexity of inflation modelling is high. Energy and supply constraints seem to exhibit persistency. Second round wage inflation effects are highest in the US compared to other OECD countries. The question that requires an answer is when will tightening financial conditions for real economic agents have a negative impact on investment for corporates versus spending for the consumer.

As long as the labour market remains buoyant, initiating a real change in corporate and consumer sentiment, one that depresses inflation, will take monetary (and fiscal) courage. The textbook or historical comparisons are of little use for what’s ahead. However, we do have some rules of thumb that might be helpful as we experience a rare moment in US monetary policy over the next 12 months. Because, indeed, if inflation has not backed off by late September, expect the steady 50bp increment to be applied over the November 2 and December 15 FED meetings. That would finish off 2022 with a FED policy rate at 3.25%-3.50%.

Under the above scenario, expect the US curve to fully invert and keep that inversion intact. Within the market, we have witnessed a brief 2-year vs 10-year US rate inversion between April 1 and April 4. Renewed weakness across the main US equity indices since then has pushed investors towards the safety of short-term US bonds. That has caused a temporary steepening. However, the FED is on a mission. The White House is on a mission as well and wants the ‘inflation debate’ that rages in the streets to die down urgently. The alignment of interest between the FED and the White House suits them both. The FED is fully aware that in order to anchor long-term rates, it requires them to go all-in on policy rates. Because, indeed, long-term rates are setting the level of long-term mortgage rates. The 30-year fixed mortgage rate has climbed towards 5.25%. That is 25bp above the 25-year average of about 5.00%. The White House hopes to achieve a status quo or a Democratic House as a result of the midterm elections on November 8.

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