After achieving interest rate liftoff in March, the Fed has quickly increased the trajectory of its long climb back to normal by doubling the increase in its policy rate and starting to reduce the size of its balance sheet.
The May meeting delivered lots of action but few surprises from the Federal Reserve’s Open Market Committee (FOMC). The Fed is now employing a dual strategy of normalizing monetary policy: raising interest rates at a more rapid clip and shrinking the size of its balance sheet.
The Fed raised its policy target range by 50 basis points from 0.25% – 0.50% to 0.75% – 1.00%, the largest such increase at a single meeting since 2000. While rates remain very low by historical standards, every indication from Fed speakers, including Chair Jerome Powell, is that a lot more hiking is in store at future meetings.
The Fed’s balance sheet is now nearly $9 trillion, growing considerably in 2020 and 2021 as it tried to provide enough liquidity to keep the financial system upright during the initial shock of the pandemic and the resulting economic disruption. Many of those assets – up to $95 billion per month once the program is in full swing – will now be permitted to mature without replacement as the Fed responds to lower demand for liquidity (i.e., cash) with lower supply. Just how long this quantitative tightening program will be in place is hard to say. The Fed’s description of its plans noted that the roll off is likely to end “when reserve balances are somewhat above the level it judges to be consistent with ample reserves.” In other words, the Fed would rather stop too early than too late, especially as it considers interest rate hikes to be its preferred and primary tool for tightening policy.
Growth and inflation in the balance
The health of the U.S. economy came into sharper focus at this meeting after first quarter GDP data unexpectedly showed a contraction. While the details showed private sector demand holding up well, no central bank wants to embark on a tightening cycle when the economy is teetering on the edge of a technical recession.
Striking the correct balance between bringing down inflation and keeping the multi-pronged economic expansion intact – thereby achieving a so-called soft landing – will challenge both the Fed’s policy acumen and its rhetorical powers in the coming months. Financial conditions have already tightened somewhat but need to tighten further to bring core inflation back down to a more acceptable range.
The upbeat description of consumer and business spending in the first quarter, as well as its assessment of the labor market, shows that the Fed believes the economy is strong enough to handle the tighter monetary policy coming its way.
A few more hikes… and then what?
The next Fed meeting on June 15 will bring new economic and interest rate forecasts and, almost certainly, another 50 basis point rate hike – though markets are now pricing in some chance of an even larger hike. The FOMC appears unanimous in its desire to raise interest rates back to neutral as quickly as possible, which we see as 2.5% – 2.75%. We see the federal funds rate reaching this range by the end of 2022, implying that the pace of hikes will slow or even pause as inflation falls.
What may lie beyond “neutral” will depend on how the inflation and labor market data evolve, specifically the intersection of the two: wage growth. Wages show conflicting evidence. The Employment Cost Index rose by more than expected in the first quarter, which the Fed will consider a clear sign that tighter policy is needed to forestall a wage-price spiral. But company surveys do not indicate further large wage hikes and the recent huge increase in labor force participation seems likely to relieve some upward pressure on compensation.
One possible proof point will be in the path of job openings, which we found out this week hit an alltime high of 11.5 million in March. As long as there are roughly two open jobs for every unemployed worker looking for one, the upward pressure on wages – and, eventually, inflation – will remain high and the Fed will feel it needs to keep hiking.
Is it time to buy?
Investors may have noticed the very rapid rise in interest rates during the first four months of 2022, accompanied by falling stock prices and widening corporate credit spreads. In short, nothing has worked. But with inflation still unusually high, hanging onto cash at these still-very-low interest rates does not seem to us like a winning strategy. At the same time, moving aggressively into riskier assets with recession risks looming or allocating to interest-rate sensitive portions of the bond market may both seem like hazardous bets.
We think long-term investors should be cheered by the sharp drop in valuations across most publicly traded asset classes this year. The yield on the Bloomberg U.S. Aggregate Bond Index has not been this high since briefly in 2018, and, before that, in 2010. The S&P 500 is valued about the same today as just prior to the pandemic. Over longer periods, valuation drives a large percentage of total return.
Of course, even brief periods of sharply rising interest rates tend to cause investors to pull their money out of fixed income, a trend that is particularly pronounced in municipal markets. But we see no commensurate deterioration of fundamentals in either municipal or corporate credits that would justify the sharp correction that occurred this year. Given the risk of persistent inflation and a further rise in rates, it may not be time to jump with both feet into the longest of long-duration assets just yet. But as risks become more balanced between high inflation and low growth, we think bringing some macro hedges – namely duration – back into portfolios at these valuations seems like a risk worth taking.
On the equity side, a further normalization (i.e., a slowing of demand) in the economy would likely be good for growth stocks, which have been pounded as investors favor a combination of energy and ultradefensive sectors. Of course, it’s hard to see any portion of the global equity market performing well as long as interest rates are increasing at a rapid clip and recession concerns are increasing.
The third leg of the stool for diversified investors in this hot economy remains real assets, which often carry a combination of solid growth potential, a natural resistance to inflation and higher yields than publicly traded fixed income. Whether publicly traded or privately-structured, real assets and real estate have held up well in the extremely challenging environment 2022 has brought so far.