Best Hawkish Behavior

In the anxious aftermath of the June CPI report, among the worst in modern US history, markets priced a full-percentage point rate hike from the Fed as a coin toss at this month’s policy meeting.

Late last week, when preliminary PMI data for July suggested private sector US economic activity contracted this month, markets briefly priced a 75bps hike as less than certain.

The about-face was indicative of the tug of war between an inflation crisis that threatens to undermine whatever’s left of the Fed’s institutional credibility and a decelerating economy which, if allowed to slip into recession, could likewise turn public opinion against the Fed, whose efforts to combat runaway price growth risk being castigated as cold-blooded — the spiteful machinations of unelected technocrats convinced that fixing their last mistake requires committing an even larger error.

There are no good options — no “right” choices. It’s possible Fed hikes will prove wholly ineffective to combat an inflation impulse born in severed supply chains and inflamed by a war. Unequivocal statements about the primacy of the inflation fight aside, Fed officials haven’t indicated an appetite for real, across-the-board demand destruction. To critics, including Bill Dudley, the economic projections accompanying the June meeting were unrealistic. A Fed that will only countenance an unemployment rate of 4.1% isn’t a Fed prepared to combat 9% inflation, the argument goes.

Notwithstanding the return of acute recession angst courtesy of last week’s flash reads on S&P Global’s PMIs, a 75bps hike is a foregone conclusion at this week’s FOMC meeting. Several banks understandably adopted 100bps as their base case in the immediate aftermath of the June CPI report, but such a move seems unlikely now. Last week’s housing data was uniformly poor, jobless claims are rising, the economy is decelerating and the first read on University of Michigan inflation expectations for this month was relatively benign.

The market is priced for easing next year (figure above) when, traders assume, the Committee will revert to something that at least vaguely resembles a growth-conscious mentality. Whatever the case, count the market skeptical about the sustainability of any trek into restrictive territory.

There’s certainly a case for a 100bps move this week, but if the Fed were to go that route, it’d wrong-foot markets at a delicate juncture. Maybe that’s precisely what’s needed. Forward guidance, the gold standard for policymaking in the era of perpetually subdued inflation and moribund growth, is now dead. Nobody read the fine print on the package: “Perishable. Discard immediately if inflation exceeds target by more than two percentage points for two consecutive months.”

But just as this Fed isn’t willing to adopt a scorched earth approach to demand destruction, neither is it keen to completely blindside markets. Even last month’s eleventh hour pivot to 75bps was telegraphed via the Wall Street Journal. The ECB, which explicitly disavowed forward guidance on rates last week, still felt the need to leak the Governing Council’s inclination to a larger hike increment to Bloomberg ahead of the decision.

It’s tempting to declare a 50bps increment from the Fed this week off the table. There are three risks to a downsized increment. First, it’d send a dovish message to markets, chancing a rally in risk assets, tighter credit spreads and a weaker dollar, ironically raising the odds of the Fed having to do more at the September meeting given the read-through of easier financial conditions for inflation. Second, it could convey panic about the impact of rate hikes on the economy at a time when Fed officials are at pains to convince markets (and some lawmakers) that they won’t waver until price stability is restored. Third, doubts about the resiliency of the economy sowed by a hypothetical downshift to 50bps increments could quickly overwhelm the initial knee-jerk reaction in risk assets, leading to severe whiplash for stocks, as “Dovish hike!” euphoria is replaced by “What do they know that we don’t?” angst.

The only reason not to rule out 50bps entirely is the proximity of the advance read on Q2 GDP and, the following day, the breakout of personal spending data for June, alongside PCE prices (and ECI). Forgive me, but if the Fed doesn’t get a look at all of that data prior to making a decision this week, then the machinery of government is even more broken than I thought. I don’t know what official protocol is, and I don’t care. Everyone involved should take the simple steps necessary to avoid a slapstick routine wherein the Fed, out of consensus, decides on a 100bps hike and the BEA unofficially declares the economy in recession 18 and a half hours later, only for Friday’s data to inject still more confusion.

“Despite lingering odds of a new last-minute change of heart by the Fed, we think… a stronger-than-expected CPI report cemented the view that the Fed will repeat June’s 75bps dose, as reverting to a 50bps rate increase will be inconsistent with recent hawkish Fed guidance,” TD’s Oscar Munoz, Priya Misra and Gennadiy Goldberg said. “We also judge that the bar to hike by 100bps is fairly high. Unlike last month, Fed officials had ample opportunity to ‘communicate [their] thinking as clearly as [they] can’ prior to the start of the blackout period [and] most officials who managed to provide remarks poured cold water on the 100bps hike idea,” they added.

“The BoC’s recent 100bps hike and the ECB’s 50bps move provide plenty of cover for the Fed to hold the 75bps line, even if the combination of Fedspeak and media leaks confirm 100bps isn’t on the table,” BMO’s Ian Lyngen and Ben Jeffery wrote. 50bps, they said, “isn’t an option” for the July meeting. Assuming that’s true, it’s still an option for September, though, and if there are no surprises on Wednesday, that’ll be the focus of Jerome Powell’s press conference.

“Until recently, the market’s operating assumption was that by forgoing a 100bps hike in July, the Committee would lock in a 75 hike in September [but] weaker European PMIs and similarly uninspired US PMIs has led to a collective rethink of the inevitability of 75bps on September 21,” Lyngen and Jeffery added.

The market plainly believes recession odds have risen since the June gathering. Yields are sharply lower, terminal rate pricing has come down by almost 50bps and nearly one full 25bps hike increment has been priced out for 2022. “Lead or follow?” SocGen’s rates team wondered, noting that the June dots effectively top ticked market pricing (figure below).

“The slowdown in economic activity and increasing risks of global recession might make it hard for the Fed to continue to raise rates despite persistent inflation,” strategists including Adam Kurpiel and Subadra Rajappa wrote, noting that although the US “remains resilient in the face of higher rates and surging costs, the sharp decline in consumer and business sentiment, the decline in housing activity and manufacturing and the steady rise in initial jobless claims augur for the potential for a meaningful slowdown.”

Absent favorable developments in Ukraine and China (which the Fed absolutely can’t depend on, let alone wait around for), the only way out of this is for the Committee to do precisely what they’ve promised — namely, raise rates at a steady, even onerous, clip, until i) inflation recedes in the face of a fairly significant deceleration in domestic economic activity or ii) there’s a plausible case to be made that monetary policy has done everything it can do. We’re nowhere near either of those outcomes.

“Ironically, the best path forward for equities is to see the Fed stay on its best hawkish behavior for longer than is currently being priced,” Nomura’s Charlie McElligott said. “When they do crunch demand hard enough to start a deeper slowdown and see inflation roll over, rates will pick that up with an initial steepening as the front-end then correctly reprices the end of the tightening cycle, which means equity multiples can finally stop the bleeding.”