June FOMC Preview: 75 is the New 25

Please note that the this article has been edited from what was originally published on June 13, 2022, due to a change in our call from a 50bp to a 75bp rate hike this week, as well as in July.

We are now looking for the Fed to lift rates by 75bps this week, bringing the Fed Funds rate to 1.50-1.75%, despite previously giving clear prior guidance of 50bp increases for the June and July FOMC. According to media outlets (which it appears the Fed may be quietly speaking to, in a highly unusual move for them), the FOMC is now leaning toward a more front-loaded hiking cycle after another hot CPI report on Friday and inflation expectations showing signs of de-anchoring. We believe this shows the Fed is more determined to do what it takes to end the inflation overshoot as rapidly as possible, even if that raises the chance of a hard landing in 2023.

We also expect the Fed to tighten policy by 75bps in July and then, after reaching neutral, to slow the pace to 50bp in September and November. We pencil in two further 25bp increases for the December and February meetings, for the Fed Funds rate to reach a terminal rate of at least 3.75%-4.00%.

We believe that as we surpass neutral before end-2022, which Fed officials have noted should be around 2.50%, divergences in the optimal policy path projected by Fed members will become more evident. As inflation began to rage during the second half of last year and at the beginning of this year, the Fed coalesced around a view of hiking rates rapidly toward a more neutral stance. But as we get there and move above it, activity is likely to begin showing more clear signs of cracking. At that point, the calculus for some Fed officials is likely to change.

In the meantime, we anticipate the Fed will double down on its hawkish stance this week. U.S. Chair Powell's post-meeting press conference and the Fed's update to the dot plot will send a clear signal that the Fed intends to lift rates rapidly above neutral before the end of the year. Furthermore, we expect Powell to reiterate the message that FOMC is determined to adopt the necessary measures to achieve price stability even if that means hiking rates meaningfully above neutral. In that sense, the chairman's communication is likely to sound hawkish, but we judge that to be necessary to maintain financial conditions on a restrictive tilt and keep inflation expectations from de-anchoring.

Apart from Powell's press conference — where he is likely to field questions about the FOMC's short-term policy guidance, the Fed's reaction function, recession odds, and possible asset sales — we believe the Fed's update to its Summary of Economic Projections (SEP) will be one of the most relevant in recent years. Indeed, we anticipate the FOMC will send an unambiguous signal that it intends to restrict the policy stance this year and next by a higher degree than it had anticipated at the March meeting (the last time the SEP were submitted). In effect, we look for the dot plot medians to signal a tighter policy path for both this year and 2023 even if that means assuming a higher risk of recession. That risk will likely be visible in the Fed's projection of a higher path for the unemployment rate through the forecast horizon, with the profile for the series likely inching closer to the 4% level by the end of 2024.

The rates market has further increased the pricing for the FOMC hiking path since the May meeting, with strong May CPI and then the last day or two of media reports pushing pricing for hikes even higher amid fears that inflation is running out of control. Investors are now pencilling in 280bp of additional Fed rate hikes for the rest of this year and a terminal Fed funds rate of about 4% by mid-2023, up from 2.90% in late-May.

While we do look for growth to moderate later this year, we don't see it decelerating yet to below-trend levels. We believe the Fed is likely to continue beating a hawkish drum at the June meeting. This will likely keep 10y Treasury yields in a 3.4-3.5% range in the near-term as the Fed retains the optionality to tighten rates further above neutral in the autumn. While there is a risk that asset prices weaken further, which keeps the 10y from rising too quickly, we believe real rates are set to rise further. 5y5y real rates are now close to 1% after spending most of 2021 around -40bp. The rise in real rates should negatively impact the economy and financial conditions.

While a 75bp rate hike is fully priced in at this week's meeting, the market's reaction will likely hinge on several questions:

• How much will the 2023 dots rise? We expect the median Fed dot for 2022 to shift from 1.875% to 2.875% and the 2023 dot to shift from 2.75% to 3.375%. Any indication that the Fed intends to overshoot more than the market anticipates in 2023 is likely to drive bear flattening price action.
• Will the FOMC forecast rate cuts into 2024? This could make markets nervous that the Fed intends to notably overshoot neutral in the near-term and that growth is likely to slow in the future, flattening the curve.
• Will the long-run dot rise? The entry of new forecasters should push the long-run dot from 2.375% to 2.5%.
• When does the Fed move back to smaller 50/25bp hikes? How much does it need to see inflation decelerate before it feels comfortable to slow the pace of rate hikes?
• How worrying is the tightening in financial conditions? Fed speakers have previously highlighted that financial conditions tightening will help slow economic growth momentum. We don't see Powell viewing the tightening as excessive, which could keep risk assets under pressure.
• What will SEP inflation suggest? We expect an upward revision to 2022 inflation but downward revision to 2023, implying that inflation will normalize faster given Fed actions but from a higher level.
• What is the impact of quantitative tightening (QT)? While Fed speakers have suggested that runoff is equivalent to 2-3 25bp rate hikes, any discussion of the impact of QT could be market moving. For example, if Powell hints that QT is priced in and is happening in the background, the market may price in more near-term tightening via rate hikes.

We have flipped long USDs recently, preferring short EURUSD and long USDCAD positions following the ECB decision last week. Both of those have rapidly moved in our favour, and we have already taken profit in EURUSD. The Fed funds curve looks to have largely priced in our policy profile over the balance of the year. We are wary that there may be a sell-the-rumor, buy-the-fact dynamic around this Fed meeting. A bounce in EUR may be self-limiting however, as the more that hikes get priced in globally, the greater the macro and fragmentation risks may be for the common currency.

Currently, and with core m/m CPI yet to show signs of weakness, this is a USD dominant FX environment. Given this backdrop, we think it will be particularly difficult to upstage the USD.; Our read of positioning flagged more neutral on a tactical basis ahead of U.S. CPI. While this has started to tilt toward USD longs given the market volatility in recent days, the balance of risk on Fed surprises leans towards doing more, not less. We also think that the Euribor curve has neared pricing in max ECB tightening for this year (which is effectively close to our own expectation for policy). Without an offset from EUR rates, the USD could still extend dominance near-term particularly as it peels away from relative equity performance and its correlation with data surprises has strengthened