After four interest-rate hikes, what will the Fed do next?

On July 27, the U.S. Federal Reserve hiked interest rates for the fourth time this year, raising them by another 75 basis points. What does this tell us about the FOMC and what does it mean for growth?

Fed pivot? We don’t think so

You’d think markets would’ve reacted negatively to such an aggressive policy action from the U.S. Federal Reserve (Fed); instead, equities rallied, the U.S. dollar weakened, the yield curve steepened, and market-based measures of inflation rose. The markets seemed to have zeroed in on the idea that the Fed will take a more data-dependent approach to interest-rate decisions instead of being singularly focused on tamping down inflation at all costs.

Given that it’s now widely accepted that growth could slow meaningfully through the rest of the year, conventional wisdom would in theory imply that the pace of rate hikes will slow in the coming months. It’s no doubt a logical assumption, but we wouldn’t be so quick to categorize what transpired at the last Fed meeting as a pivot that changes the narrative.

In our view, the Fed has retained its hawkish bias and will continue to raise rates into year end even as headline inflation eases a touch while remaining uncomfortably high. That said, the story will become more complex in 2023 when economic growth and the inflation level are likely to have slowed much more substantially—only then do we expect the Fed to begin an easing cycle. Ultimately, the central bank has introduced a significant amount of uncertainty in regard to future interest-rate decisions and the indicators it’ll be using to guide its thinking. Fed Chair Jerome Powell noted that the FOMC will be “nimble in responding to incoming data and the evolving outlook”—economists and strategists should too. 

Secured Overnight Financing Rate futures
Chart showing how market pricing of secured overnight financing rates has changed between these dates: June 28, July 21, and July 28, 2022. The chart shows that the rate has fallen significantly in the month since June 28, 2022.

Source: Bloomberg, Macrobond, Manulife Investment Management as of July 28, 2022.

The importance of being back at neutral

July’s rate hike was significant in that it brought the federal funds rate within the range of the Fed’s estimation of the neutral rate, that is, the rate at which monetary policy is neither expansionary nor contractionary. This is an important milestone for two reasons.

First, it means that any rate hikes from here on out would be considered restrictive from a growth perspective. Many Fed officials have been clear that they believe in the need to move above neutral in order to contain inflation, and that’s one of the reasons why we expect the Fed to continue to raise rates into year end. That said, the bar for future rate hikes is now much higher and we expect the magnitude of forthcoming hikes will be smaller. The key question for investors going forward is the extent to which the Fed might change the magnitude of its rate hikes (i.e., from 75bps to 50 bps or 25bps) and just how much further the Fed can hike without inflicting meaningful damage to the economy. As of now, we expect the Fed to hike 50bps in September, 25bps in November, and end its hiking cycle with a final 25bps hike in December; however, the risks to our forecast are for fewer hikes of a smaller magnitude as the Fed climbs higher and higher above the neutral rate.

Second, the Fed has historically struggled to raise rates much above the neutral rate and has had to reverse course fairly quickly in the past. Historically, the median time between the last rate hike and the first interest-rate cut is seven months. In light of the highly recessionary environment we’re likely to experience in end-2022 and early 2023, it makes sense that markets are pricing in rate cuts (as measured by Secured Overnight Financing Rate curves) beginning in 2023 and continuing into 2025. Likewise, we anticipate rate cuts to begin next year, but only midyear as we believe inflation—while slowing—will remain too high for the Fed to pivot before then. We’re also expecting bigger cuts than markets have currently priced in.

From forward guidance to data dependence

Speaking at the press conference following July’s FOMC decision, Chair Powell implied that the Fed will be moving away from forward guidance and toward meeting-by-meeting decisions that reflected incoming data. This begs the question: What data is the Fed watching and what would it take for the central bank to truly pivot?

On one hand, Chair Powell’s opening statement reiterated that inflation remains a top priority and that he was looking for compelling evidence of improvements in inflation. In the past, he has referenced both month-over-month declines in headline inflation and inflation expectations (both consumers’ and markets’). In regard to the latter, the Fed can probably begin to breathe a sigh of relief since market-based measures of inflation, known as breakevens, have eased materially from earlier this year despite remaining above prepandemic levels. Problematically, official headline inflation (both the Consumer Price Index and Personal Consumption Expenditure) is likely to stay uncomfortably high to year end, leaving the Fed with little flexibility to stop hiking altogether.

On the other hand, the FOMC acknowledged the recent slowdown in economic activity in its July statement, which makes sense since nearly every leading indicator of U.S. growth pointed downward, with jobs being the only exception. In the past year, the Fed has only needed to worry about the inflation aspect of its dual mandate, but we expect that to change soon as leading indicators such as initial jobless claims suggest that the labor market’s about to enter a much shakier period. Indeed, we believe the United States will enter a formal recession by early 2023, accompanied by higher unemployment. That should kick-start the U.S. central bank’s transition back toward its dual-mandate setting. The seeds of that shift have been sowed; now, we wait for the jobs data to shift decisively, enabling the Fed to make a genuine (and sustained) pivot.

U.S. break-even yields
Chart comparing U.S. break-even yields of different durations (two-year, five-year, and 10-year) from July 2012 to data available as of July 28, 2022. The chart shows that the U.S. break-even yields for all three durations have fallen significantly in the past few months.

Source: Bloomberg, Macrobond, Manulife Investment Management, as of July 28, 2022.

The Fed’s balance sheet’s shrinking and no one’s quite sure how to think about it

The Fed massively expanded its balance sheet in the depths of the COVID-19 crisis, buying U.S. Treasuries and mortgage-backed securities as a means of injecting liquidity into the financial system. These asset purchases continued well into the recovery, ending only in March this year. The central bank has since reversed course and is now engaging in quantitative tightening (QT), shrinking its balance sheet by not reinvesting a portion of its maturing securities. The Fed is scheduled to shrink its balance sheet at an accelerating pace until it reaches a US$95 billion monthly pace by September.

The challenge here is that the impact of QT isn’t well understood, particularly when compared with the impact of rate hikes and conventional policy tightening. The Fed’s last (and only) experience with QT took place between 2017 and 2019, a period that coincided with greater equity market volatility and lower yields. This introduces substantial uncertainty into the environment and important questions will need to be considered: Will engaging in QT in such an environment produce liquidity issues? Will the Fed have to slow its rate hikes sooner in order to accommodate balance sheet tightening? Once again, we’re left with considerable uncertainty around the Fed’s policy outlook that shouldn’t be underestimated. 

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments.  These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice.  This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional

Australia: Manulife Investment Management Timberland and Agriculture (Australasia) Pty Ltd, Manulife Investment Management (Hong Kong) Limited. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad  200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltdwhich is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Manulife Investment Management Timberland and Agriculture Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

 

556993

Frances Donald

Frances Donald, 

Global Chief Economist and Strategist, Multi-Asset Solutions Team

Manulife Investment Management

Read bio
Eric Theoret, CFA, CMT

Eric Theoret, CFA, CMT, 

Global Macro Strategist, Multi-Asset Solutions Team, Manulife Investment Management

Manulife Investment Management

Read bio