Fed Regains Inflation Fighting Credibility by Hiking +0.75% Extra Large Hike Lowers Probability of Prolonged Tightening
The Fed raised rates +0.75% this week and guided to a +0.50% to +0.75% increase at the July meeting. The Fed also stated it's strongly committed to bringing inflation back down to 2%. Taking a step back, the Fed traded in its 'guidance credibility' for 'inflation fighting credibility'. It's a good trade in our view. The Fed has been behind the curve for most of the pandemic recovery – initially calling inflation transitory and then starting the tightening cycle and balance sheet drawdown later than the market wanted. Being behind the curve allowed investors to control the narrative and determine the appropriate terminal rate level. By proceeding with a +0.75% increase at the June meeting, the Fed has started the process of regaining control of the narrative. The Fed signaled it's willingness to front load rate hikes, which should act to address inflation pressures earlier and decrease the risk that inflation becomes entrenched. The move essentially puts a ceiling on the projected terminal rate. If the Fed didn't make the trade, it risked losing even more credibility, falling even further behind the curve, and having to be even more aggressive later.
The market was a complete mess heading into the meeting. The issue was nobody, including the Fed, knew how aggressive the Fed would need to tighten to contain inflation. The market's imagination took over, and the narrative pushed the terminal rate higher and higher. With an ever increasing and uncertain terminal rate, investors couldn't accurately or confidently value assets or calculate the risk/reward. The Fed's actions decrease this valuation uncertainty by lowering the probability of the worst case scenario where the Fed loses control of inflation and is forced to keep aggressively raising rates (i.e., sustained rate hikes).
In our view, the Fed's actions represent a potential market turning point. The terminal rate 'ceiling' gives investors more information to value assets. Quicker, bigger rate hikes decrease the potential of prolonged tightening, which lowers the projected terminal rate and in turn favors higher P/E multiples. It's also likely to stabilize the Growth factor, weaken USD, and slow the yield surge higher. We caution the Fed's actions don't necessarily set the market up for a massive rally, and the upside is still likely capped. However, they represent the first step toward stabilizing the market and slowing the bleeding.
The big macro downside is the +0.75% increase, and potential for continued aggressive rate hikes, pull forward the economic impact and the potential timing of a recession. Our fear continues to be the Fed will destroy demand and negatively impact economic growth without addressing inflation's root cause – high energy prices. It will be difficult to tame inflation due to structural (i.e., lower oil driller capex) and geopolitical (i.e., Russian oil bans) energy issues driving inflation higher. The Fed has exactly zero tools to directly address these issues and push energy prices lower. However, the +0.75% rate hike and a commitment to front loading rate hikes puts the potential for a soft landing back on the table. While a soft landing is still a difficult, low probability task to pull off, getting inflation under control sooner allows the Fed to pause sooner and potentially prevents it from being forced to continually and purposefully destroy demand. This gives the Fed more options down the road, which is a good thing. It's a step in the right direction, and the right call This material was prepared by Market Desk for financial advisor use.
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