Federal Reserve (Fed) Governor Brainard’s hawkish comments signal the Fed will start lifting its fed funds rate in 50bps steps after March’s initial 25bps rise to 0.25-0.50%. The usually dovish official said: ‘inflation is much too high and is subject to upside risks.’ Thus, the Fed would ‘continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.’
We thus revise our Fed call and now anticipate 50bps hikes in May and June followed by 25bps moves at each following meeting until fed funds hits 2.75-3.00% in March 2023. We also expect the Fed will start reducing its balance sheet from May to unwind its pandemic quantitative easing (QE). Previously, we had forecast 25bps hikes at each remaining Fed meeting this year and quarterly 25bps hikes next year. We thus see a steeper path of Fed tightening now with the faster hiking cycle ending in 12 months’ time as inflation starts to fall back towards the Fed’s 2% goal. This is likely to have the following implications:
Source: Bank of Singapore, Bloomberg.
Third, faster tightening is set to push the fed funds rate above estimates of neutral near 2.50%, raising fears the economy may fall into recession as interest rates reach ‘restrictive’ levels around 3.00%. The chart shows the spread between 2Y and 10Y Treasury yields has already briefly inverted - historically a signal recession is coming.
We expect US yield curves may invert for the next six months as the Fed hikes in larger 50bps steps in May and June. But we don’t think the US economy with its strong tailwinds from reopening and tight labour markets will contract this year despite faster Fed hikes. The chart also shows the ‘near-term forward spread’ - the difference between 3 months Treasury bills and their forward rate in 18 months’ time, a more reliable indicator according to Fed Chair Powell - is steeply sloped, implying growth is expected to stay resilient over the next six quarters despite upcoming Fed hikes.
Last, we expect Treasury and swap curves will become positively sloped again between 6- and 12-months’ time as the Fed nears the end of its hiking cycle, reducing upward pressure on short term 2Y yields. Shrinking the Fed’s balance sheet will also help steepen the yield curve. By shedding longer dated 10Y and 30Y Treasuries more than 2Y and 5Y bonds, quantitative tightening (QT) will put upward pressure at the longer end of the curve, helping to end inversion.
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