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Market snapshot: Fed ramps up policy response to runaway inflation

Insight
8 April 2022 |
Active ESG
US central bank to begin speedy reduction of its balance sheet as officials lean towards 50bps rate rises this year
  • The Fed plans to start shedding up to $95bn of assets a month from its bloated $8.9tn balance sheet
  • Aggressive policy response unlikely to ease investors’ concerns that sharp increase in rates could bring about a US recession

Investors are keeping a particularly keen eye on the direction of central bank policy as runaway inflation shows no sign of slowing down. The inversion of the US treasury yield curve last week highlighted fears that Federal Reserve tightening in response could bring about a recession.

The release of the minutes this week from last month’s US Federal Reserve board meeting will have done little to assuage these concerns, highlighting officials’ willingness to aggressively raise rates1. The Fed also plans to start shedding up to $95bn of assets a month from its bloated $8.9tn balance sheet, possibly from May, at a pace twice as fast as its previous effort between 2017-20192.

“The Fed seems minded to go aggressively in coming months, ramping up the use of all its policy levers,” says Silvia Dall’Angelo, Senior Economist at Federated Hermes3. The US central bank raised its benchmark interest rate by 25bp on March 16, but the minutes showed support for a sharper 50bp increase, which was only quelled by uncertainty surrounding Russia’s invasion of Ukraine. The minutes suggest that larger 50bp rate increases remain on the cards at the next couple of meetings.

“The Fed is now well aware it is behind the curve and scrambling to catch up with a deteriorating inflation picture. However, its opportunity window might be limited, as the combination of a new round of cost-push inflation (stemming from the war in Ukraine) and fiscal and monetary tightening might lead to a stagflation scenario before too long,” Dall’Angelo adds.

Geir Lode, Head of Global Equities at Federated Hermes, says a likely outcome from the Fed’s reactive rather than proactive response is a “longer series of higher interest rate hikes than would have been the case had the Fed moved more aggressively earlier on”.

Figure 1: Implied Fed funds target rate

Graph showing implied Fed funds target rate

Source: Bloomberg (March 2022). The Fed offers forward guidance with its dot plot every quarter. Each dot represents a member of the Federal Open Market Committee (FOMC) and their view on where interest rates should be.

Growth concerns

Expectations of a more aggressive US rate hiking cycle coupled with balance sheet reduction in the US triggered a major sell off in US treasuries across various maturities. The yield on the 10-year US treasury note had risen to 2.63% at 14:20 GMT on Thursday.

On top of the conflict in Ukraine, concerns over an economic slowdown in China, which is grappling with one of its worst outbreaks of Covid-19 since the pandemic began, added to fears about weaker performance in emerging markets. The World Bank downgraded its 2022 growth forecasts for east Asia and Pacific this week to 5%, from 5.4%, and warned that growth could slip to 4% if conditions deteriorated4.

“Against this backdrop, Euro High Yield outperformed US High Yield this week, whilst High Yield ended the week higher than Investment Grade,” says Fraser Lundie, Head of Fixed Income – Public Markets at Federated Hermes.

The pan-European Eurostoxx 600 Index closed down 0.24% on Thursday as investors weighed whether the European Central Bank would follow the Fed’s more aggressive monetary policy approach5. France’s CAC 40 Index, meanwhile, closed down 0.57% following a bumpy week in which far-right politician Marine Le Pen closed the gap on incumbent Emmanuel Macron ahead of the first round of Sunday’s presidential election.

“Dramatically higher gas and electricity prices and fuel prices are sure to crimp discretionary spending in the coming months. This has already been seen in consumer confidence indicators. Pressure to raise interest rates will only compound this,” says Chi Chan, Portfolio Manager – European Equities at Federated Hermes.

For further analysis on European equities, access our latest Sustainability Report. For additional analysis on the outlook for emerging markets access our Meeting Room Webcast.

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The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

1 US stocks end lower after Fed minutes point to tighter monetary policy | Financial Times

2 Fed prepares to slash size of swollen balance sheet by $95bn a month | Financial Times (ft.com)

3 Federated Hermes refers to Federated Hermes Limited.

4 East Asia and Pacific Economic Update (worldbank.org)

5 Bloomberg

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