Investors are bracing for a hard landing as the US Federal Reserve further tightens its monetary policy, with another 75bp interest rate increase early this morning Hong Kong time. This is the second time in as many months that the US Fed has raised interest rates by this much as it attempts to combat inflation, marking a historical moment in central banking.
The Hong Kong Monetary Authority (HKMA) also raised the base rate by 75bp to 2.75% effective immediately in keeping with the HKD-to-USD peg rate. The base rate is the reference for the borrowing cost.
The jury is still out on the impact of the Fed’s go-for-the-jugular approach, but many investors and asset managers are worried that its aggressive efforts to rein in inflation may push the fragile global economy, already reeling from the pandemic and the war in Ukraine, into a recession.
“We believe the probability of a recession has risen considerably, reflecting concerns over the threat of policy overtightening by the US Federal Reserve,” says Erik Weisman, chief economist and portfolio manager of MFS Investment Management. “The Fed funds future curve is projected to exceed the estimated neutral rate by a significant margin. When considering the Fed’s dual mandate, Chairman Jerome Powell has made it clear that he is far more focused on containing inflation than safeguarding economic growth.”
Weisman’s assessment comes just before the US Fed announces the second 75bps rate hike in two months in its bid to tamp down strong inflationary pressure that is threatening the global economy.
Blerina Uruci, US economist at T. Rowe Price, notes: “After a whirlwind week, market pricing has also settled on a 75bp hike, following three broad developments: declining inflation expectations in the University of Michigan survey, softening activity data, and Fed speak showing the FOMC does not have the appetite for larger hikes.”
The bellwether federal funds rate is expected to hit 3.75%-4.0% this year following the successive rate hikes. The US central bank is expected to ease up of rate hikes as soon as it is able to bring the rising inflation to manageable levels but it is unlikely to cut rates in the near term.
“There is more uncertainty about the outlook for 2023 than the market pricing suggests, in my view,” Uruci says. “With high and sticky inflation and the unemployment rate at historical low levels, the Fed will probably not be able/willing to respond to slowing activity by cutting interest rates as fast as it would have done before the pandemic.”
But what worries many investors and asset managers, however, is that the Fed has signalled that it stands ready, if necessary, to engineer a recession as a collateral risk in its unconditional fight against inflation.
Be less aggressive
“Should a hard landing materialize, it is likely the Fed would change gears and re-engage in policy easing, but only if inflationary dynamics are safely back in the box,” Weisman says. “Overall, the US economy is facing a period of significant volatility and uncertainty, and there is a wide range of potential outcomes.”
Data from Trading Economics indicate that the annual inflation rate in the US accelerated to 9.1% in June 2022, the highest since November 1981, from 8.6% in May and above market forecasts of 8.8%. In Hong Kong, the annual inflation rate rose to a six-month high of 1.8% in June 2022 from 1.2% in the previous month, beating market expectations of 1.6%.
With the likelihood of a recession, fixed-income investors are advised to be less aggressive on short-duration bonds and there is a lower probability of longer-term rates moving much higher from current levels.
“Rates at the front-end of the curve may remain susceptible to continuing high inflation, a robust labour market and a hawkish Fed, with the risk of further increases to short-term rates persisting,” Weisman says. “If macroeconomic fundamentals continue to deteriorate and a recession does materialize, we expect a widening of credit spreads, which will require careful analysis and security selection to help manage credit exposures.”