Fed hikes rates by 50 bps, signals bond unwinding

5 May 2022 , 09:22 AM

Till now, the Fed has stuck to what it has stated. It promised to unwind fresh purchases by March, which was done. It had promised to start rate hikes in March 2022 and the Fed did start off with 25 bps rate hike. However, the May Fed meet was to be a different ball game altogether. The Fed in general and Jerome Powell in particular had committed to hike rates by 50 bps in May-22 and also commence bond book unwinding.

With CPI inflation at 8.5% in Mar-22, there was not much of a choice. In his Fed statement, Jerome Powell did announce a 50 bps rate hike. Effectively, between Mar-22 and May-22, Fed rates have moved up 75 bps from the range of 0.00%-0.25% to a range of 0.75% to 1.00%. The Fed also instructed to start bond book unwinding from June onwards, although it will be a prismatic graduation to avoid liquidity shocks.
However, the US markets appeared enthusiastic. The Dow Jones closed 932 points higher and the Dollar Index fell from above 103 to 102.47 levels. Even the 10-year bond yields in the US fell from above 3% to 2.93%. Markets are enthused by the bond unwinding starting off on a cautious note, which is positive for financial market liquidity. But, first, the most authentic indicator, CME Fedwatch.

CME Fedwatch hints at 2.75%-3.00% rates by end of 2022

CME Fedwatch captures probability of rate hikes at future meetings based on the yields implied in Fed Futures trading. Here are implied Fed rate scenarios over next 10 meetings.

Fed Meet	75-100	100-125	125-150	150-175	175-200	200-225	225-250	250-275	275-300	300-325	325-350
Jun-22	21.4%	78.6%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Jul-22	Nil	Nil	20.9%	77.0%	2.1%	Nil	Nil	Nil	Nil	Nil	Nil
Sep-22	Nil	Nil	Nil	11.7%	52.3%	35.1%	0.9%	Nil	Nil	Nil	Nil
Nov-22	Nil	Nil	Nil	Nil	10.9%	48.9%	34.6%	5.5%	0.1%	Nil	Nil
Dec-22	Nil	Nil	Nil	Nil	0.2%	10.6%	45.7%	37.1%	6.2%	0.1&	Nil
Feb-23	Nil	Nil	Nil	Nil	0.1%	4.3%	24.5%	42.5%	24.8%	3.6%	0.1%
Mar-23	Nil	Nil	Nil	Nil	0.1%	1.6%	11.0%	30.1%	36.5%	18.0%	2.7%
May-23	Nil	Nil	Nil	Nil	Nil	1.0%	7.7%	23.7%	34.6%	24.3%	8.7%
Jun-23	Nil	Nil	Nil	Nil	Nil	0.7%	5.5%	18.5%	31.0%	27.7%	16.2%
Jul-23	Nil	Nil	Nil	Nil	Nil	0.7%	5.3%	17.5%	29.5%	27.5%	18.8%

Data source: CME Fedwatch

Normally a probability in the range of 25% to 30% is a strong indication of affirmative action.

• With the Fed hiking rates by 50 bps in May-22, 75 bps rate hike is already done. The Jun-22 rate hike is expected to be just 25 bps to allow markets to adapt.
• Fedwatch pegs the interest rates in the range of 2.75%-3.00% by December 2022. That means, remaining 5 meetings could see, at least, two hikes of 50 bps each.
• At least, for now, the Fed has not been deterred either by the Ukraine war or the China shutdown or even by the risk of monetary divergence with other central banks.
• The consensus appears to be a long-term rate of around 3.25%-3.50 in the US, which means bulk of the rate hikes would be done before the end of 2022.
• Post the May-22 rate hike of 50 bps, there was a spike in probabilities of rate hikes across 2022, implying that markets expect Fed to front-end rate hikes.

The Fed has left a small escape route in the policy statement, should economic conditions sharply worsen as an outcome of persistent rate hikes.

Key takeaways from the May-22 Fed statement

The Fed statement by Jerome Powell on 04th May has two messages. Fed wants to control inflation with dear money and also amplify it with liquidity cuts. Here are key takeaways.

1. The 50 bps rate hike in May-22 was the largest up-move in rates in the last 22 years. This clearly indicates that the Fed is willing to take emergency steps on a persistent basis to handle the monster of inflation.
2. The Fed statement underlined that the primary goal of the May-22 policy was to curb inflation, which was hitting the most vulnerable sections of America. With consumer inflation at 8.5%, Fed has committed that it would be price stability above all else.
3. One look at the Dot-Plot chart (consensus estimates of rates by FOMC members) indicates that nearly 80% of the proposed rate hikes would be completed in 2022. For now, the Dot-Plot is expecting a worst case rate scenario of 3.25% to 3.50%
4. Jerome Powell, Fed Chair, ruled out 75 bps rate hikes in any of the coming meetings, hinting that 50 bps would be the maximum it would go. However, another two rounds of 50 bps rate hike look on the cards before the end of 2022.
5. On the bond unwinding, the Fed decided to tone down its aggression. Instead of starting with $95 billion a month, it will start at $47.50 billion of unwinding from Jun-22 and then scale it up to $95 billion by Sep-22. Fed feels, this should be sufficient amplification.
6. Effective June, the bond unwinding would be $30 billion of treasuries and $17.5 billion of mortgage backed securities. After 3 months, this unwinding would be scaled up to $60 billion of treasuries and $35 billion of mortgage backed securities.
7. While the FOMC expressed confidence in the ability of the US economy to handle the rate hikes, it did admit that the US economy activity had edged lower in the first quarter. Fed also admitted that the rate hikes could negatively impact the growth momentum.

In an interesting aside, the Fed statement acknowledged that the risks of COVID-related shutdowns in China and the supply chain bottlenecks could hamper growth. However, Fed has said, it is more concerned about the impact of supply chain on inflation.

Will the Fed rate decision impact India?

Not much; for 3 reasons. Firstly, the 50 bps rate hike was expected and already factored into the market calculations. Secondly, the lower than expected bond unwinding would actually be positive for markets like India that are liquidity dependent. At least, the expected impact on passive flows will be much lower than expected.

But the big reason is that the RBI has pre-empted the Fed impact by proactively raising rates by 40 bps on 04th May. This takes away the big question of “How the RBI will react”. The impact of the Fed rate hike, if any, should be limited on Indian markets.