U.S. FOMC rate hikes and the impact on borrowing U.S. dollars

It appears likely that the U.S. Federal Open Market Committee (FOMC) will announce a 50-basis point hike in U.S. Funds at their May meeting. This expectation was widely telegraphed, with U.S. Federal Reserve Chair Jerome Powell himself recently acknowledging the hike would be on the table.

That move is in line with our expectations and would also be consequent with the fact that, already in March, "many participants... would have preferred a 50-basis point increase" if it weren't for the near-term uncertainty created by the Ukraine-Russia conflict.

In that context, we believe the focus for markets will lie elsewhere, particularly on any guidance regarding the U.S. Fed's policy path in the near term. We expect Powell to bring home the message that the Committee is ready to front-load interest rate hikes as it seeks to get monetary policy to a more neutral stance before the end of the year.

Balance sheet runoff plans will also be in the spotlight. Specifically, quantitative tightening (QT) plans are likely to be announced at the May meeting and implemented starting June 1, with a 3-month phase-in period. Note that QT will not be an "active" policy, occurring in the background as policy rates remain the main tool for the Fed to respond to an evolving economic outlook.

QT will continue until the earlier of two scenarios:

• The banking system sees signs of reserve scarcity
• The Fed begins to cut rates

Given our view that the Fed will be able to achieve a soft landing, we expect QT to continue until late 2024, at which point we may see some signs of reserve scarcity emerge. At that point, the Fed is likely to slow the pace of QT before ending it entirely. We estimate a total U.S. Treasury and mortgage-backed securities (MBS) runoff of US$500B in 2022 and US$950B in each of 2023 and 2024.

While financial conditions have tightened since the Fed's sharp pivot in its policy outlook, they have further room to run given that the absolute level remains accommodative despite the recent spike in real rates, widening in credit spreads, and decline in equities. In our view, the Fed is more than happy to be more candid with its near-term policy views so that markets continue to incorporate its more hawkish guidance and tighten financial conditions while policy gets to neutral.

This will be a challenging balancing act for the Fed because it wants conditions to reflect the fact that monetary policy is set to tighten rapidly (particularly at a time when the economy remains strong), but at the same time the Committee does not want to overdo policy tightening above neutral if inflation/growth show signs of turning over.

This is the main reason we do not currently expect the Fed to accelerate its hiking pace above 50bp per meeting. The Fed is aiming to bide its time while it gets the Fed Funds rate to neutral in order to better assess the impact that tighter financial conditions are having on the real economy.

That said, Powell is unlikely to take the 75bp hike option entirely off the table and is likely to be questioned on the topic at his post-meeting press conference. It is not our base case, however, and we note that not a single FOMC member has endorsed a 75bp hike as their base case. But Powell could endorse consecutive 50bp rate hikes, which would largely serve the same purpose.

We ultimately look for the Fed to:

• Hike by 50bp in each of the May, June, and July meetings
• Hike by 25bp at each meeting between September and March
• Reach a nominal terminal rate of 3.25%

We think that the backdrop of rushing to a neutral Fed Funds rate to quell inflation is a key linchpin to our "race to the top" theme in FX. This means that many central bankers, and especially the Fed, will use currency strength to offset goods inflation if it means containing neutral/terminal rate expectations. Fortunately for the Fed, the USD is a great shock absorber of price pressures from abroad. Lately however, the broad USD's strength has not been firm enough to offset the rapid climb in goods inflation. The latter is the worst since the early 1980s, an era that was defined by former U.S. Federal Reserve Chair Volcker's hikes and later by former U.S. President Regan's fiscal profligacy.

The gap between goods inflation and broad USD will need to close, and it is likely that the Fed wants a stronger dollar, particularly if it improves the chances to contain neutral/terminal rate pricing. From this perspective, it is certainly a good reason to maintain a hawkish stance and leave the possibility of 75bp hikes alive amid fluidity around terminal rate pricing. With QT coming out in full force, this means that king USD will be exceptionally difficult to dethrone in the currency complex.

Markets are well priced for a 50bp hike and the announcement of QT at this meeting. With no Summary of Economic Projections or dot plot released at this meeting, the market's reaction will hinge on the message in the statement and Powell's press conference regarding a few unknowns:

• Taking Fed funds above neutral and tolerance for above-target inflation: While there is a remarkable amount of consensus at the Fed about reaching the neutral rate (which most FOMC members see in the 2-2.5% area), there is little consensus on how much tightening the Fed needs to deliver to slow inflation. Powell is unlikely to provide overly concrete details, but if he suggests that a large overshoot of the neutral rate may be necessary, markets may react hawkishly.
• MBS sales: The January FOMC minutes suggested that the Fed might consider MBS sales once QT is well underway. We don't expect the Fed to undertake active sales since we believe that sales will have a disproportionate impact on longer-term rates and the housing market.
• Financial conditions: Monetary policy acts on the economy via the financial conditions channel. As such, Powell's characterization of financial conditions will be crucial to watch. Different measures have implied various degrees of financial conditions tightening, and it would be interesting to see exactly how much tightening the Fed believes has taken place.

The Fed is unlikely to sound committed toward any policy path beyond reaching the neutral funds rate in an "expeditious" manner. With inflation at uncomfortably high levels and uncertainty about the inflation outlook persisting, the Fed will likely opt to keep all options on the table. However, we think that with long-end rates moving higher due to QT, financial conditions are set to tighten further. In addition, consumers will be dealing with lower purchasing power due to elevated inflation and fiscal drag. This can cause consumer spending to slow in the coming quarters, helping to cap the rise in rates.