75bp rate hike: back to the future, the 1994 edition

No one really believed it back in March when the President of the St Louis Federal Reserve, James Bullard, touted the possibility that the Fed would have to raise rates by 0.75 basis points at a single meeting to ward off inflation. However, a mere three months’ later, and here we are. The Federal Reserve hiked rates by 0.75bps on Wednesday, pushing up US interest rates to 1.5% - 1.75%. This is the largest rate increase since Bill Clinton was in office in 1994, and the highest level for US interest rates since before the pandemic. Even Fed Chairman Jerome Powell said that Wednesday’s rate increase was incredibly large, and thus would be a rare event. However, he did not rule out another 50bp or 75bp rate hike at the Fed’s meeting in July.

What comes next?

The market had already rushed to price in mega single rate hikes from the Fed earlier this week after US inflation came in above expectations for last month. For example, there is now a near 80% chance of repeat 75bp rate hike at the Fed’s next meeting on 27th July. The Federal Reserve also released their latest projections for growth, inflation and its Dot Plot of future interest rate expectations. According to this Dot Plot, the Federal Funds rate will end the year at 3.4%, which is a significant upward revision of 1.5% from the bank’s March projections. This highlights how much monetary policy expectations have shifted, in recent months as inflation has taken hold. The Fed also cut its US growth forecast for this year. It now expects the US economy to grow by 1.7% this year, which is down from the 2.8% rate it expected in March. Regarding growth forecasts, we continue to think that the Fed, and other economic organisations, are over-optimistic on the growth prospects for the US, due to the ferocity of the Fed’s path for interest rates in the coming months. This has started to bite the US consumer, there was a decline in US retail sales for May, headline retail sales fell by 0.3% and sales ex-autos rose by 0.5%, lower than the 0.8% expected. Combined with a weaker NY Empire State Manufacturing Index along with a disappointing NAHB housing index for June, and the picture for the US economy looks fairly drab, albeit brighter than it does for Europe and the EU. Thus, the tightening from the Fed is happening at the same time as US growth is tailing off.

The worrying thing for investors is that the Fed knows that what it is doing could jeopardise economic growth, yet it continues to persist in its fight against inflation. In its statement on Wednesday, the Federal Reserve removed its phrase that it “expects inflation to return to its 2% objective and the labour market to remain strong.” Instead, it said that it remains “strongly committed” to these objectives. Thus, the Fed’s mandate looks like it is shifting as the bank tries to fight inflation that is raging at a 41-year high. This subtle shift in the Fed’s language suggests that it will either 1, tolerate high inflation, or 2, tighten rates to such an extent that it will create unemployment. Neither is a good option for the Fed; however, we think that the latter is more likely. Our reason for this is that elevated inflation is devastating for an economy in the long term, thus the Fed may choose to hike rates aggressively in the short term, which could lead to some short-term economic fallout.

Why stocks are rising

Surprisingly, US stock markets actually closed higher after the Fed meeting late on Wednesday. The S&P 500 is currently trading 1.3% higher in the after-hours market, and the Nasdaq Composite rose more than 2% by Wednesday’s US market close. US bond yields have also moderated, the 10-year yield is down some 19 basis points, while the 2-year yield is down 20bps to 3.22%. The reason for this “euphoria” after the Fed meeting is down to two factors: 1, there was some fear that the Fed would surprise the markets and raise rates at an even faster clip of 1% or above, and 2, Chairman Powell said that he does not expect to have to raise rates by 75bps for long, he even said that the FOMC is undecided about whether they should raise rates by 50bps or 75bps next month. Welcome to the new world where a 50 bp rate hike from the Federal Reserve is considered dovish! However, the market might be cheered by signs that the Fed is trying to get ahead of the curve when it comes to inflation. Thus, even if it causes some short-term economic pain, at this stage interest rate hikes should not hurt the US economy and corporate profits in the long term.

The market looks ahead to the days when the Fed will have to ease rates

Ahead of today’s FOMC meeting, the activist hedge fund investor Bill Ackman tweeted that 100bp rate hikes would be preferable in the coming months so that the Fed can get to its terminal rate as soon as possible and thereafter can begin to ease rates. While Ackman did not get his 100bp rate hike, and the Fed backed away from a hike of this magnitude in future, the Fed is likely to reach its terminal rate sooner than previously expected. The Fed’s Dot Plot suggests that rates will end this year at approx. 3.4%, and next year at 3.8%. Thus, the Fed expects its pace of tightening to slow sharply in the next few months. If the US economy reacts quickly to the Fed’s rate hikes, then they could even start to ease rates next year. That is the scenario the market may be pricing in right now. Thus, any sign of economic weakness in the shorty term could be bought into as we enter a phase where bad news is good news for stock prices.

From a sector perspective, the gains were broad-based, however, they were more pronounced in growth stocks, with large-cap tech names rising 3% or more on Wednesday, and in growth-sensitive areas like banking that also had a decent performance. Energy stocks fell, as the prospect of a US recession caused by Fed tightening could lead to a dip in the demand for oil in the coming months. The dollar was also knocked post the Fed’s meeting, as the market looks ahead to the prospect of Fed easing monetary policy perhaps as early as next year. The dollar index fell some 0.5% on Wednesday. This was partly down to technical factors, for example, GBP/USD bouncing back above the technically important level of $1.20 as we lead up to the BOE meeting on Thursday. The dollar also came under pressure after USD/JPY backed away from the 135 level, and as EUR/USD moved back towards $1.0450 after the ECB promised to support the southern Eurozone bond markets. Overall, we still think that it is too early to call an end to the bear market, added to this, we are not convinced that the dollar won’t rally once more. We think that the flight to risky assets post the Fed meeting may be temporary, and due to the plethora of fundamental factors that are driving this market right now, we prefer to keep our trades short term.