First rate hike, with 6 more now penciled in for 2022
Over the past six months, the U.S. Federal Reserve (Fed) has faced plenty of criticism for being behind the curve, inflation took off. Against this backdrop, the Fed delivered what was expected in their March Federal Open Market Committee (FOMC) meeting: a 25-basispoint hike, the first so since 2018. More importantly, U.S. central bankers went out of their way to signal their intention of doing their utmost to dampen inflation expectations. For 2022 the Fed’s summary of economic projections shows a lower path on growth, a much higher path on inflation and an upward surprise on the willingness to tighten monetary policy: 7 hikes of 25 basis points for 2022 are indicated and 4 more for 2023 – surpassing market expectations. These hawkish projections come with a lot of confidence: growth and inflation projections for 2023 and 2024 converge to their equilibrium levels without hurting the labor market much.
As for shrinking the Fed’s outsized balance sheet, its Chair Jerome Powell said that would start at a “coming” meeting without providing any further details on how they intend to proceed. This could well reflect the recent deterioration of financial conditions. Commenting on the gruesome war Russia’s President Putin has unleashed in Ukraine, Fed Chair Powell stated that the implications for the U.S. economy are highly uncertain. Overall, as we expected, the Fed repositions itself as an inflation fighting institution and surprised significantly on the envisioned path of interest rate hikes.
Market and policy implications
Monetary policy was never likely to be easy in 2022. Commenting on U.S. labor markets, Powell described it as “very, very tight”, going so far as stating that the tightness had reached unhealthy levels. At this stage, the priority for him and the vast majority of his colleagues is clearly to prevent high inflation from becoming entrenched “no matter what happens”. A series of commodity price shocks, unprecedented economic sanctions in the wake of Putin’s war and Europe’s refugee crisis all create additional uncertainties. The Fed does not have a crystal ball and remains data dependent. Whether it will actually hike rates to 2.8%, compared to a neutral rate now seen at 2.4% will depend on future events. Its current projections see U.S. economic growth at 2.8% for 2022, a cut from 4% at the last FOMC and below market consensus. By contrast, the Fed’s estimate for its preferred inflation measure based on Personal Consumption Expenditures (PCE) has risen to 4.3% (from 2.6%) but much less so in 2023 and 2024. The Fed, in other words, is still pretty confident in achieving a soft landing: getting inflation down without triggering a recession.
Monetary policy was never likely to be easy in 2022
Fixed Income & Currencies: Market reactions so far have been muted. The Fed’s first hike had been widely expected and indeed, before the start of Putin’s war, markets had begun to price in a potential increase of 50 basis points at this week’s FOMC, instead of the 25 basis points eventually delivered. Our baseline scenario for the U.S. remains “growthflation” and we expect a slight flattening of the U.S. Treasury curve for both, 2-10 and 10-30 year horizons. Stagflation might be best guess for Europe for now, reflecting the higher dependency on events in Ukraine and Russian energy supplies. Fixed-income spread asset markets look set to remain volatile for the time being. As for currencies, there are currently so many moving parts that it is hard to make long-term forecasts with a high degree of confidence. To take the dollar and the Euro as an example, the Fed’s rate rise and further plans will widen the nominal yield differential, which should be supportive for the dollar. Despite this, there are two counterbalancing factors. Softening of the rhetoric from both Ukraine and Russia has led to a sharp drop of the inflation expectation in the Eurozone amidst hopes that the commodity shock might not turn out as severe and long-lasting as markets feared a week ago. The real yield differential is thus turning supportive of the Euro. And improving sentiment regarding global growth after the Chinese officials recently pledged to support the equity market and Powell’s positive tone on the prospects for U.S. economic growth support the pro-cyclical currencies, including the Euro. Needless to say that the picture on all these drivers could well look quite different in a week, let alone a month or a year from now!
Alternatives: Seen in isolation, we expect the impact of higher U.S. interest rates to be limited for both private infrastructure and U.S. Real Estate. Most infrastructure debt financings are long-term and at fixed rates. These have mostly been refinanced at historically low rates over the past years, which generally protects infrastructure assets from increases in the nominal costs of debt. Moreover, networks and some other assets, for example and the Regulated Asset Base (RAB) scheme in the U.K., can recover interest rate increases via tariff increases. To be sure, interest rate increases may put pressure on discount rates and valuations, particularly for assets with limited regulatory support or lower earnings growth potential. In a potential stagflation scenario in Europe, core-RAB regulated infrastructure may outperform in the medium-term, but diversification across core plus and value-added strategies would arguably still be preferable from a long-term investment perspective. Similarly, in U.S. real estate, higher short-term rates will not necessarily drive longer-term rates higher. To the extent that longer-term rates are rising, it is largely due to rising inflation, which is positive for real estate. Real (inflation-adjusted) interest rates are still deeply negative. Real estate yields continue to offer an attractive spread against real rates on inflation protected government bonds.