FOMC meeting: 50 Bps is baked in, but what comes next?

As UK markets get ready to go back to work on Tuesday after the May Day Bank Holiday, the FOMC meeting that concludes this Wednesday is the key focus for market watchers this week. The meeting concludes at 1900 BST, with the all-important press conference from Fed chair Powell at 1930 BST. The market is overwhelmingly priced for a 50bp rate hike from the Fed at this week’s meeting, which would be the first double rate hike for 22 years. What is more astonishing is that there is a 90% chance of a second 50 bp rate hike in June, and an 86% chance of a 50 bp hike to 200-225bps in July. By year end the market is expecting US interest rates to be in the 3% range, which is a huge move considering rates were essentially at 0% at the start of this year. 

The Fed’s terminal rate 

The hawkish shift in Fed policy is causing shock waves around the world as the terminal rate, which would mark the end of the current Fed hiking cycle, continues to move higher. A rough guide of where the market thinks the Fed’s terminal rate will be is the 5-year Treasury yield, this broke above 3% on Monday, as US and global bond yields surged higher. The US yield curve (10-year yield – 2-year yield) is dipping back towards inversion territory, which is considered a recession risk. However, at the start of this week, what is interesting about the US yield curve is that the entire curve is moving higher. This is unusual, since when equity risk aversion is high, as it has been recently, you usually see some areas of the US yield curve (such as 10-year Treasuries) act as haven assets. That is not the case this time, and the reason is that this economic cycle is different because inflation is out of the bottle. Everyone knows that this will be a difficult disease to treat. The medicine is also harsh: an extremely aggressive Fed tightening cycle, which is likely to hurt the economy. 

The Fed and inflation: why the Fed needs to hike

The Fed is likely to come up against some criticism for its aggressive hiking cycle on Wednesday, especially after the weak Q1 GDP report for the US. However, the Fed is likely to say that it will look through one quarter of bad growth, as it continues to believe that consumer spending is resilient on the back of strong wage growth for Q1. The BLS employment cost index for Q1 rose to a more than 22-year high. This is a clear sign that as we progress through 2022, the global inflation problem is more than just a supply chain issue. Added to this, labour market data for April is expected to show 390k jobs were created by the US economy last month. This suggests a robust economy and could also propagate further wage growth down the line. Thus, when people say that the Fed can’t target inflation because it’s caused by outside pressures and the war in Ukraine, this is not wholly true. If wage pressures are surging in the US, then the Fed can try to put the brakes on the US economy to make sure these wage increases are nipped in the bud before they get out of control. Thus, at this stage, we cannot guarantee that the US terminal rate will not rise above 3% when annualised wage growth is the highest in two decades. The surge in the BLS’s employment cost index, suggests that price rises are becoming embedded in the economy, and this is the reason why it's hard to find any doves left at the Fed. 

QT is coming, but what will it look like? 

While the market is fully priced for a 50 bp rate increase this week, the FOMC statement and press conference will be more interesting from the perspective of the Fed’s enormous $9trillion balance sheet. We expect a formal announcement about the Fed’s plans to reduce the size of this monstrosity, and we could get confirmation that it will sell assets to the tune of $98bn per month in the coming months. This would be a much larger pace of monetary tightening compared with 2017, although the Fed could start small with a $50bn shrinking of its balance sheet this month. Overall, the Fed is embarking on a supersized tightening cycle using both interest rates and QT in unison. This is something that the market has not had to deal with before, and it is causing severe risk aversion in equity markets.

Will traders follow Warren Buffet and buy when there is blood on the streets? 

There was a risk off tone to markets at the start of the week as the Fed-led shift in global monetary policy continues to weigh on sentiment. However, the declines in US markets were markedly smaller than they were last week. Oversold conditions, depressed sentiment and positioning indicators could also limit further downside from here. It will be interesting to see if a swathe of traders will follow the ‘Sage of Omaha’ into buying stocks at these depressed levels, after Warren Buffet said that he was a buyer after the recent steep declines in stocks. If stocks rise on the back of forward-looking expectations that the Fed’s hiking cycle will be brutal, but short, then we could see the dollar drop. 

The week ahead 

Looking ahead, the ISM manufacturing report is also worth watching this week after Chinese manufacturing and non-manufacturing PMIs came in weaker than expected on Monday. The new orders component in the ISM manufacturing survey fell for March, however the market anticipates that the manufacturing and service sector surveys for the US picked up last month. Since this survey can be a lead indicator for US stocks, it is worth watching it closely as it may give the value names in the US a boost. Elsewhere, the BOE and RBA also have meetings this week.

Earnings season update 

With more than half of the S&P 500 having reported Q1 earnings, the score card is as follows. 80% of companies have reported a positive EPS surprise, with  72% reporting a positive revenue surprise, although earnings growth has slowed to 7.1%, the slowest quarterly rate of growth since Q4 2020, according to FactSet. So far, 26 companies listed on the S&P 500 have issued negative EPS guidance for the coming quarters, with 17 companies issuing positive guidance. While this is a low number, it is concerning that more companies are issuing negative guidance compared to positive guidance. It is worse in the UK where the number of profit warnings for UK companies has risen to a record as inflation pressures bite. This is the trouble with a service-based economy like the UK. When inflation rears its head it’s easy to cut back on service-based activities, which is why UK companies are struggling. This is less likely to impact the FTSE 100, but it is a problem for the broader FTSE index.