September FOMC Preview : Following the Fed Higher
By: Oscar Muñoz, Priya Misra, Gennadiy Goldberg, Andrew Kelvin, Mazen Issa
September 19, 2022 - 11 Minutes
After the stronger US inflation data for August, showing that core inflation momentum accelerated from July, we've seen rate expectations rise even further for most major central banks, and our own Strategy team has lifted terminal rate forecast across all major regions. Next week's FOMC meeting should set the stage for another wave of hawkish central bank decisions through the autumn, before the pace of rate hikes finally begins to slow into the end of the year. We summarise our global changes of view below.
The last FOMC meeting in July appeared to set the stage for a situation where the Fed could plan out a route for rate hikes over the remainder of 2022 to get to a sufficiently positive inflation-adjusted fed funds rate level by year-end or early 2023. The July CPI report hinted at a start of a more moderate inflation path, opening the possibility for the Fed to embark on a steady path of rate hikes of somewhat smaller magnitudes than seen at the June and July meetings.
The August CPI report, however, threw a wrench in the spanner. Although headline inflation for August moderated on the back of retreating gasoline prices, the monthly core CPI inflation rate of 0.6% massively overshot the consensus expectation of 0.3%, an unhealthy upside surprise reminiscent of the May CPI report. And not only did the August CPI report wipe out the deceleration in monthly core inflation rates seen in July, but the strong core CPI print was also supported by a broad range of categories beyond the dominant, and sticky, rent inflation component. Couple this with financial markets pricing with almost certainty a 75bp rate hike in September before the August CPI report came out, and the Fed cannot afford not to deliver on those expectations. A 75bp upward move in the fed funds target range at the September FOMC meeting is therefore a given.
The last FOMC meeting in July appeared to set the stage for a situation where the Fed could plan out a route for rate hikes over the remainder of 2022 to get to a sufficiently positive inflation-adjusted fed funds rate level by year-end or early 2023. The July CPI report hinted at a start of a more moderate inflation path, opening the possibility for the Fed to embark on a steady path of rate hikes of somewhat smaller magnitudes than seen at the June and July meetings.
The August CPI report, however, threw a wrench in the spanner. Although headline inflation for August moderated on the back of retreating gasoline prices, the monthly core CPI inflation rate of 0.6% massively overshot the consensus expectation of 0.3%, an unhealthy upside surprise reminiscent of the May CPI report. And not only did the August CPI report wipe out the deceleration in monthly core inflation rates seen in July, but the strong core CPI print was also supported by a broad range of categories beyond the dominant, and sticky, rent inflation component. Couple this with financial markets pricing with almost certainty a 75bp rate hike in September before the August CPI report came out, and the Fed cannot afford not to deliver on those expectations. A 75bp upward move in the fed funds target range at the September FOMC meeting is therefore a given.
More Front-Loading to a Higher Terminal Rate
Between the September and November meetings, the FOMC will only have one labour market and one CPI report to further inform their decision-making process. In our view, these are too few data points to fundamentally change the high inflation picture we have now. As such the FOMC, we think, will need to repeat September's 75bp hike at its November meeting.
By the time of the December meeting, there will be more scope for the data to suggest that the economy is close to showing signs of a more desirable inflation path, opening up the possibility for a slightly less aggressive fund funds rate increase of 50bp. This 50bp hike in December should be seen as a final push to get the funds rate in a range of 4.25%-4.50%, levels at which the FOMC should be more confident (given its own one-year ahead inflation projections), that positive real interest rates will prevail through 2023. In combination with slowing inflation next year, this should result in enough inflation-adjusted policy tightening to bring inflation eventually back on a persistent downward path towards the 2% target. We, therefore, expect that the FOMC will be content with reaching a fed funds target range of 4.25-4.50% in December and will strive to stay at those levels for most of 2023.
By the time of the December meeting, there will be more scope for the data to suggest that the economy is close to showing signs of a more desirable inflation path, opening up the possibility for a slightly less aggressive fund funds rate increase of 50bp. This 50bp hike in December should be seen as a final push to get the funds rate in a range of 4.25%-4.50%, levels at which the FOMC should be more confident (given its own one-year ahead inflation projections), that positive real interest rates will prevail through 2023. In combination with slowing inflation next year, this should result in enough inflation-adjusted policy tightening to bring inflation eventually back on a persistent downward path towards the 2% target. We, therefore, expect that the FOMC will be content with reaching a fed funds target range of 4.25-4.50% in December and will strive to stay at those levels for most of 2023.
Market Implications
For rates, the market is priced for 81bp of hikes at the meeting and the terminal rate has risen to 4.4% due to continued high inflation readings. We think a hawkish Fed message is priced in, though in the case of a 2023 median dot closer to 5%, that could extend the recent moves. We remain in 2s10s flatteners, long 3y and long 30y real rates.
In FX, while it's tempting to buy the rumour/sell the fact for the USD, we prefer to be neutral. While the curve has aggressively repriced terminal, there is some risk that Powell could channel Volcker on messaging. Over the balance of the year, we still see more USD strength. We are closely watching USDCNH and the 7.00 level; we think this will eventually break but doing so sooner will drag USDJPY higher as well as USD/G10 given correlation profiles.
In FX, while it's tempting to buy the rumour/sell the fact for the USD, we prefer to be neutral. While the curve has aggressively repriced terminal, there is some risk that Powell could channel Volcker on messaging. Over the balance of the year, we still see more USD strength. We are closely watching USDCNH and the 7.00 level; we think this will eventually break but doing so sooner will drag USDJPY higher as well as USD/G10 given correlation profiles.
4.00% for the Bank of Canada: More Mountain to Climb
Through the first quarters of the year, the questions facing the BoC have been fairly straightforward. The economy was moving further into excess demand, inflation was persistently surprising to the upside, and until July, policy rates were in accommodative territory. It was plainly evident that rates needed to go higher, and aggressively so.
Going forward the balancing act will be trickier; growth has shown notable signs of slowing amid a rapid tightening in financial conditions, and we look for GDP growth to lag behind population growth for the next 4-5 quarters. The sharp increase in the unemployment rate in August looks like a statistical anomaly, but we do we expect to it grind higher through 2023. Inflation looks to have peaked now that North American energy prices have moderated, but it remains painfully, unacceptably high. We don't expect inflation to fall below 4% until April, and don't foresee a move back to 2.0% until some point in 2024.
In a more typical cycle, the Bank would probably be content to pause here given the growth outlook, and let inflation gradually fall back to target. However, the Bank has expressed concern that the persistently high short-term inflation expectations will bleed into longer-term expectations, which will make achieving the 2% target more difficult over the long-run. In this context, the Bank may feel a pressing urgency to bring inflation under control more quickly, leading to a higher terminal rate than would otherwise be deemed necessary.
Going forward the balancing act will be trickier; growth has shown notable signs of slowing amid a rapid tightening in financial conditions, and we look for GDP growth to lag behind population growth for the next 4-5 quarters. The sharp increase in the unemployment rate in August looks like a statistical anomaly, but we do we expect to it grind higher through 2023. Inflation looks to have peaked now that North American energy prices have moderated, but it remains painfully, unacceptably high. We don't expect inflation to fall below 4% until April, and don't foresee a move back to 2.0% until some point in 2024.
In a more typical cycle, the Bank would probably be content to pause here given the growth outlook, and let inflation gradually fall back to target. However, the Bank has expressed concern that the persistently high short-term inflation expectations will bleed into longer-term expectations, which will make achieving the 2% target more difficult over the long-run. In this context, the Bank may feel a pressing urgency to bring inflation under control more quickly, leading to a higher terminal rate than would otherwise be deemed necessary.
Finding a Balance
The September communiqué was short, to the point, and offered only the most minimal forward guidance (rates will go higher). We believe the fact that the Bank isn't comfortable communicating that the pace of rate hikes will moderate necessarily shifts the distribution of terminal rate outcomes to the right. 3.50% looks like the absolute lowest plausible outcome, and we'd view anywhere between 3.50% and 4.75% as plausible depending on the level of concern with the BoC's credibility. The key question isn't "how much will the Canadian economy slow?", but "will the BoC care?", which itself is going to be a function of both CPI and inflation expectations.
3.50% is clearly not modal, and with the Fed expected to lift rates by another 2ppts from here a 3.75% terminal rate in Canada also looks too low. At the same time, we emphasize that each successive rate hike will weigh more heavily on Canadian households (and more so than they will on US households). A 4.00% terminal rate strikes a nice balance.
We expect the pace of BoC tightening to slow in coming meetings, and now that policy settings are firmly into restrictive territory we think the most prudent course of action would to move in 25bp increments. At the same time, market expectations have a way of becoming self-fulfilling — with questions lingering about credibility, the BoC cannot risk material downside surprises relative to market expectations. We are going to pencil in 3 consecutive 25bp moves from the BoC, reaching 4.00% terminal by January 2023 — but that is explicitly contingent on October OIS pricing falling to at least 3.60% (or thereabouts). If current pricing for October holds up, the Bank will be forced to hike 50bp next meeting.
3.50% is clearly not modal, and with the Fed expected to lift rates by another 2ppts from here a 3.75% terminal rate in Canada also looks too low. At the same time, we emphasize that each successive rate hike will weigh more heavily on Canadian households (and more so than they will on US households). A 4.00% terminal rate strikes a nice balance.
We expect the pace of BoC tightening to slow in coming meetings, and now that policy settings are firmly into restrictive territory we think the most prudent course of action would to move in 25bp increments. At the same time, market expectations have a way of becoming self-fulfilling — with questions lingering about credibility, the BoC cannot risk material downside surprises relative to market expectations. We are going to pencil in 3 consecutive 25bp moves from the BoC, reaching 4.00% terminal by January 2023 — but that is explicitly contingent on October OIS pricing falling to at least 3.60% (or thereabouts). If current pricing for October holds up, the Bank will be forced to hike 50bp next meeting.
Taking What the Market Gives: Reassessing the BoE and ECB's Policy Paths
Data and central bank speak have been in the driver's seat the past two weeks. Generally speaking, data continues to point to sustained inflationary pressures (especially from the labour market), and central bankers have come back from their holidays with a renewed hawkishness.
In light of our forecast change for the fed funds rate (both at the coming meetings, and for terminal), we reassessed and revised our forecasts for the rate paths of the UK and euro area. It now looks like the major G4 central banks are all likely to deliver 75bps hikes this month. Central banks are taking whatever hikes the markets are willing to give them, and we see little reason for this pattern to ease until inflation starts to come under control.
In light of our forecast change for the fed funds rate (both at the coming meetings, and for terminal), we reassessed and revised our forecasts for the rate paths of the UK and euro area. It now looks like the major G4 central banks are all likely to deliver 75bps hikes this month. Central banks are taking whatever hikes the markets are willing to give them, and we see little reason for this pattern to ease until inflation starts to come under control.
Bank of England: 75bps Next Week and a Higher Terminal
It's been an eventful two weeks for the UK, with a new government, a new Prime Minister, and a new Monarch. In the midst of this, the ONS has released its top-tier economic data, which has so far painted a somewhat mixed picture, but key details are likely to be more concerning to the MPC than not.
Most notably, the labour market report for the three months ending in July was red hot. The unemployment rate slipped to a new low of 3.6%, a record for the survey that dates back to 1974. Furthermore, the 3-month annualised rate of private sector regular pay (the MPC's preferred wage measure) jumped over 1ppt to 8.5%. While employment gains have slowed, the data shows low unemployment and high wages, a picture that was very clear in the US earlier this year amidst labour shortages. We think the MPC will have been very surprised by this report, and this data is what tipped us over the edge in favour of a 75bps hike.
Beyond September's policy meeting, we expect two further 50bps hikes this year, taking Bank Rate to 3.50% by year-end, where it is likely to remain for some time. We expect the MPC to remain data-driven, and if November's budget surprises with even more fast fiscal easing, may see the MPC hiking beyond 3.50% in early 2023.
We believe that UK rates will remain vulnerable to the moves in US and Eurozone rates in the near term. After the recent sell-off led by the Eurozone and US, we believe we could see some short-term consolidation in rates. Thus, our near-term bias is for 10y Gilts to hover around 2.8- 3.0%. However, we look still look for Gilts to end the year at 2.7%, in line with our view of approaching the terminal rate into year-end. Furthermore, we believe the 2s10s/5s30s curves are more likely to steepen as fiscal policy becomes the primary driver over monetary policy. On a cross-market basis, we still look for GBP outperformance vs EUR.
Most notably, the labour market report for the three months ending in July was red hot. The unemployment rate slipped to a new low of 3.6%, a record for the survey that dates back to 1974. Furthermore, the 3-month annualised rate of private sector regular pay (the MPC's preferred wage measure) jumped over 1ppt to 8.5%. While employment gains have slowed, the data shows low unemployment and high wages, a picture that was very clear in the US earlier this year amidst labour shortages. We think the MPC will have been very surprised by this report, and this data is what tipped us over the edge in favour of a 75bps hike.
Beyond September's policy meeting, we expect two further 50bps hikes this year, taking Bank Rate to 3.50% by year-end, where it is likely to remain for some time. We expect the MPC to remain data-driven, and if November's budget surprises with even more fast fiscal easing, may see the MPC hiking beyond 3.50% in early 2023.
We believe that UK rates will remain vulnerable to the moves in US and Eurozone rates in the near term. After the recent sell-off led by the Eurozone and US, we believe we could see some short-term consolidation in rates. Thus, our near-term bias is for 10y Gilts to hover around 2.8- 3.0%. However, we look still look for Gilts to end the year at 2.7%, in line with our view of approaching the terminal rate into year-end. Furthermore, we believe the 2s10s/5s30s curves are more likely to steepen as fiscal policy becomes the primary driver over monetary policy. On a cross-market basis, we still look for GBP outperformance vs EUR.
ECB: 75bps in October and a Higher Terminal
Since last week's policy decision, where the ECB delivered a 75bps rate hike, "sources" leaks and Governing Council members' comments suggest a much more determined ECB than what came across at the time. We now think that President Lagarde had intended to sound quite hawkish in her press conference, but realised after the fact that she had not come across like this. The fact that the decision was unanimous, and that there has been little to no pushback on comments made since the press conference, suggest a more determined Governing Council than previously.
There's also been a notable shift on balance sheet policy from the ECB. The Financial Times now reports that discussions on the balance sheet are due to take place imminently, with a possible policy decision later this year. This suggests a more hawkish and determined stance from the Governing Council to bring inflation down. We suspect they will try to ensure any balance sheet reduction has as little impact as possible on the economy, but the willingness to move forward on this suggests a more resolute Governing Council.
The Governing Council's shift in attitude toward tackling high inflation and rising inflation expectations is clear. We now expect the ECB to hike its policy rates by 75bps in October, and by a further 50bps in December and 25bps in February, bringing the Depo Rate to a terminal rate of 2.25%. The risks lie toward a final 25bps hike in March to reach 2.50%, but we flag that as a risk not a base case at this stage. Weather this winter could be a determinant of that outcome.
Eurozone rates continue to see a volatile ride; US CPI and last week's hawkish ECB meeting have pushed the market's terminal policy rate to around 2.5%. With the ECB considered behind the curve compared to most central banks, we think Eurozone rates remain most vulnerable on a cross-market basis. The hawks within the Governing Council seem to have been getting their way since the start of the year, but with much hawkishness already priced in markets, duration could see some range trading from here, particularly amid supportive net supply dynamics into year-end. Our near-term bias is for 10y Bunds to hover around 1.4-1.6%, while our year-end forecast for 2022 is at 1.5%.
There's also been a notable shift on balance sheet policy from the ECB. The Financial Times now reports that discussions on the balance sheet are due to take place imminently, with a possible policy decision later this year. This suggests a more hawkish and determined stance from the Governing Council to bring inflation down. We suspect they will try to ensure any balance sheet reduction has as little impact as possible on the economy, but the willingness to move forward on this suggests a more resolute Governing Council.
The Governing Council's shift in attitude toward tackling high inflation and rising inflation expectations is clear. We now expect the ECB to hike its policy rates by 75bps in October, and by a further 50bps in December and 25bps in February, bringing the Depo Rate to a terminal rate of 2.25%. The risks lie toward a final 25bps hike in March to reach 2.50%, but we flag that as a risk not a base case at this stage. Weather this winter could be a determinant of that outcome.
Eurozone rates continue to see a volatile ride; US CPI and last week's hawkish ECB meeting have pushed the market's terminal policy rate to around 2.5%. With the ECB considered behind the curve compared to most central banks, we think Eurozone rates remain most vulnerable on a cross-market basis. The hawks within the Governing Council seem to have been getting their way since the start of the year, but with much hawkishness already priced in markets, duration could see some range trading from here, particularly amid supportive net supply dynamics into year-end. Our near-term bias is for 10y Bunds to hover around 1.4-1.6%, while our year-end forecast for 2022 is at 1.5%.
Subscribing Clients can access the full reports: September FOMC Preview: Following the Fed Higher, 4.00% for the Bank of Canada: More Mountain to Climb, and Taking What the Market Gives: Reassessing the BoE and ECB's Policy Paths on our Market Alpha portal
Vice President and U.S. Macro Strategist, TD Securities
Vice President and U.S. Macro Strategist, TD Securities
Vice President and U.S. Macro Strategist, TD Securities
Managing Director and Global Head of Rates Strategy, TD Securities
Managing Director and Global Head of Rates Strategy, TD Securities
Managing Director and Global Head of Rates Strategy, TD Securities
Director and Senior U.S. Rates Strategist, TD Securities
Director and Senior U.S. Rates Strategist, TD Securities
Director and Senior U.S. Rates Strategist, TD Securities
Director and Chief Canada Strategist, TD Securities
Director and Chief Canada Strategist, TD Securities
Director and Chief Canada Strategist, TD Securities
Director and Senior FX Strategist, TD Securities
Director and Senior FX Strategist, TD Securities
Director and Senior FX Strategist, TD Securities