Friday, December 16, 2022
It has been a painful week for those investors hoping for a shift toward dovish monetary policy. The Federal Open Market Committee (FOMC) raised rates by an expected 50 basis points (bps) on Wednesday. The surprise factor came from the updated Summary of Economic Projections (SEP), which showed policymakers moving their 2023 federal funds rate forecasts from 4.6% in September to 5.1% this month. Furthermore, several FOMC members penciled in a peak terminal rate of 5.25% or higher for next year. The SEP also showed upgraded forecasts for inflation and downgraded growth estimates for 2023 and 2024.
Outside of the U.S., the European Central Bank (ECB) also raised interest rates by 50 bps yesterday, as expected. Similar to the FOMC, forecasts for future rate hikes and commentary leaned hawkish. The accompanying policy statement noted, “We decided to raise interest rates today, and expect to raise them significantly further, because inflation remains far too high and is projected to stay above our target for too long.”
Finally, the Bank of England raised rates by 50 bps yesterday, although based on the 1.9% drop in the British pound, and reduced implied rate hike probabilities for next year, the market appeared to digest the outcome with a dovish tilt.
A notable divergence has developed in the aftermath of this week’s FOMC meeting. The Federal Reserve’s (Fed) projected federal funds rate and the implied terminal rate based on the federal funds futures market remain divided. The chart below compares the current fed funds target rate projections (orange) to the September SEP projections (grey). In addition, the fed funds futures implied rate is shown in blue. For 2023, futures are pricing in a federal funds rate of 4.4% for December 2023, compared to the actual Fed forecast of 5.1%. In addition, the futures market is also pricing in rate cuts starting as early as November 2023. From our perspective, this variance equates to elevated market uncertainty, and until market expectations and Fed forecasts align more closely, we suspect volatility could remain elevated. According to LPL Chief Economist Jeffrey Roach, “The Fed has demonstrated a penchant for forecast revisions, so we should not be surprised if the Fed revises the expected peak fed funds rate as inflation, including the sticky components, starts to moderate.”
In terms of price action, U.S. equity markets extended their post-FOMC decline yesterday and erased intraweek gains. An unexpected drop in weekly jobless claims from 231,000 to 211,000 (estimates: 232,000) further exacerbated concerns over a tight labor market, a key risk factor for a higher-for-longer policy path. The S&P 500 dropped 2.5% on the day and closed just below key support at 3,900.
Given the negative reaction to this week’s FOMC meeting, we also researched if market performance on the day of a rate hike has any implications for future equity market returns. We identified 100 rate hikes going back to 1970, filtered for rate increases occurring at least three weeks apart (there were several intra-month adjustments made back in the 1970s and 1980s that were filtered out).
As shown in the bar chart below, S&P 500 returns have been mixed immediately following a rate hike, although returns tend to improve over the following four-week period. On a more positive note, when the S&P 500 traded lower on the day of a rate hike announcement, returns over the following eight weeks averaged 0.6%, compared to only 0.1% when the index traded higher on the day of a rate hike announcement.
Overall, risk for continued volatility appears elevated until there is greater alignment between Fed policy and market expectations. Continued signs of abating inflation pressure, especially in the non-housing core services sector could help bridge the gap and reduce the degree of FOMC hawkishness.
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