Fed almost commits to rate hikes from Mar-22 onwards

27 Jan 2022 , 09:03 AM

When Jerome Powell read out the Fed statement post the FOMC meeting on 26th January, Fed rates were held in the range of 0.00% to 0.25%. But that was not the focus anyways. That is where the Fed rates have been since early 2020 when the pandemic first raised the spectre of negative growth. In the last 22 months, inflation has shot up to 7%, growth is back to normal levels and the labour situation is comfortable. The focus was, therefore, on the guidance on Fed rates; which was for an almost certain 25 bps rate hike in March and a less likely 50 bps rate hike.

Since the Dec-21 Fed meet, the benchmark 10-year bond yields have settled nearly 40 bps higher at around 1.85% levels. Since Sep-21, the Dollar Index (DXY) has moved decisively higher from 92 levels to the 97 levels. The way, Dow Jones Index gave up all its gains by close on 26th January, it was clear that markets had no doubts about the trajectory of rates. Bond buying will taper to zero levels by Mar-22 as shown in the table below.

Details	Oct-21	Nov-21	Dec-21	Jan-22	Feb-22	Mar-22
Bond Buying	$120 billion	$105 billion	$90 billion	$60 billion	$30 billion	-Nil-

So, it looks like rate hikes could start immediately after the taper is completed in early March 2022. But first, what is the CME Fed watch indicating?

CME Fedwatch shows a sharp shift towards higher rates

One indicator of the probability of rate hike and its timing is CME Fedwatch. Here are the implied probability of different Fed rate scenarios over the next 9 Fed meetings.

Fed Meet	25-50	50-75	75-100	100-125	125-150	150-175	175-200	200-225	225-250	250-275
Mar-22	87.6%	12.4%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
May-22	31.4%	60.7%	7.9%	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Jun-22	0.4%	31.8%	59.9%	7.8%	Nil	Nil	Nil	Nil	Nil	Nil
Jul-22	0.2%	17.2%	46.8%	32.1%	3.6%	Nil	Nil	Nil	Nil	Nil
Sep-22	0.1%	7.0%	29.1%	40.9%	20.7%	2.2%	Nil	Nil	Nil	Nil
Nov-22	0.1%	4.7%	21.3%	36.5%	27.8%	8.9%	0.8%	Nil	Nil	Nil
Dec-22	0.0%	1.9%	11.4%	27.4%	33.0%	20.2%	5.6%	0.5%	Nil	Nil
Feb-23	0.0%	1.4%	8.6%	22.8%	31.4%	23.9%	9.8%	2.0%	0.1%	Nil
Mar-23	0.0%	0.4%	3.4%	12.6%	25.1%	29.2%	20.0%	7.7%	1.5%	0.1%
May-23	0.0%	0.4%	3.0%	11.1%	22.8%	28.2%	21.5%	10.0%	2.7%	0.4%
Jun-23	0.0%	0.2%	1.6%	7.1%	17.3%	25.9%	24.9%	15.4%	6.1%	1.6%
Jul-23	0.0%	0.1%	1.5%	6.3%	15.5%	24.0%	24.7%	17.0%	7.9%	2.9%

Data source: CME Fedwatch

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

- It is now almost certain there will be the first rate hike in Mar-22, even as the markets are pencilling in a distinct possibility of a 50 bps rate hike to begin with.

- By June 2022, the bond futures are building in a strong likelihood of rates rising by 75 bps to the range of 0.75% to 1.00%.

- By December 2022, the Fed futures probabilities are making the case for a total of 125-150 bps rate hike, hinting at a substantial front-ending of rates.

- For now, the markets are expecting the Fed rates to stabilize around their long term target of 200-250 bps by June 2023, by when rate hikes should be substantially done.

Eventually, a lot would depend on how the macros evolve, but for now it looks like the Fed has pencilled an extremely hawkish stance for rates.

Key takeaways from the Fed statement

The Fed statement by Jerome Powell on 26-January was always supposed to have hawkish undertones. However, the Fed has left no one in doubt about its hawkish intentions.

a) Fed rates will rise in March, although the actual rate hike could vary between 25 bps and 50 bps, based on the emerging macro situation. In a telling comment, the Fed chair expressed confidence in the ability of the US economy to absorb a dose of hawkishness.

b) While the Fed confirmed that bond buying would touch zero-levels in March 2022, it was non-committal about the time table for reducing the size of its overall balance sheet. That is sensitive since the balance sheet stands at $9 trillion currently.

c) The message is that inflation at sustained high levels and a substantially improved labour market had set the base case for hiking the Fed rates without worrying about the impact on growth. Fed believes that the impact on growth momentum will be negligible.

d) One of the reasons for the hawkishness implied by the CME Fedwatch was Jerome Powell’s aggressive language. Powell has hinted at enough room to raise interest rates without threatening labour market.

e) With retail inflation at a 40-year of 7%, the Fed had no choice but to hike rates. This is the longest that Fed has waited to hike rates after a sharp spike in inflation.  Fed has hinted that high inflation may be supply driven, but it was not going away in a hurry.

f) While the Fed was non-committal on balance sheet downsizing, the FOMC has released a statement outlining “principles for reducing the size of the balance sheet”. The picture that emerges is that the Fed is preparing for significantly reducing asset holdings.

What the Fed statement means for India?

If the market reaction across Asia and India to the Fed statement is any indication, markets are expecting global investors to shift to the safety of developed markets. That explains why post the Fed statement, the US markets closed flat but Europe was sharply higher. There could be a major shift to quality at the cost of EMs.

India may find itself faced with two challenges. Firstly, higher rates will pressure the RBI to avoid too much of real-rate gap narrowing. Secondly, balance sheet contraction would mean that most of the peripheral liquidity of passive funds could reverse. Post the Fed statement, the onus is all the more on the Indian government to use the Union Budget to craft a distinct India-flavoured story. That should be the answer!