Overview of central bank supervision:
- Fed policymakers have adopted more hawkish tones, downplaying the idea that the rate hike cycle is complete and rate cuts will come in 2023.
- More importantly, the FOMC overall appears to be comfortable with US financial assets falling and the US unemployment rate rising if it means US inflation rates can be tamed.
- Rates markets see a 100% chance of a 75 basis point rate hike in September.
Recommended by Christopher Vecchio, CFA
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Rate hikes are yet to come
In this issue of Central Bank Watch, we will review comments and speeches by various Federal Reserve policymakers since last month’s Jackson Hole Economic Policy Symposium. Fed policymakers have adopted more hawkish tones, downplaying the idea that the rate hike cycle is complete and rate cuts will come in 2023. More importantly, the FOMC overall appears to be in agreement with US financial assets falling and the US unemployment rate rising if it means US inflation rates can be tamed.
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75 bps or 100 bps this week?
The tone of Fed policymakers at the Jackson Hole Economic Policy Symposium and September Fed meeting suggests a 75 basis point rate hike is very likely, even after Fed Chair Jerome Powell spoke at the Fed July meeting that proposed raising interest rates by such an extent was less likely to go ahead. Having abandoned forward guidance to adopt a data-dependent stance, the hotter-than-expected August US Inflation (CPI) report and strong August US non-farm payrolls report have reinforced the case for an aggressive tightening effort.
29.8 – Kashkari (President of Minneapolis) said that the weakness in US stock markets shows that investors have understood how serious the FOMC is about lowering US inflation rates.
August 30th – Bostic (President of Atlanta) commented in a paper published on the Atlanta Fed’s website that “incoming data — if it clearly shows that inflation has started to slow — could give us reason to refrain from hikes around 75 to withdraw basic points that the committee proposed in the last meetings implemented. We need to see that data coming in.”
Williams (President of New York) suggested that more aggressive rate hikes remain necessary as “we need to have some tightening policy to curb demand and we’re not there yet.”
August 31st – Mester (President of Cleveland) played down suggestions that the Fed would cut interest rates in early 2023.
September 1 – Bostic noted that the Fed still has “something to do” to bring inflation down and that “we need to slow down the economy.”
7th of September – Barkin (President of Richmond) bluntly stated that the Fed must raise rates to a level where they restrict economic activity. “You have to move to a level where inflation expectations come down to have enough constraint on the economy to bring inflation down.” Furthermore, he added: “The target is real interest rates in positive territory and my intention would be it is to keep them there until we are really convinced that we are putting inflation to bed.”
Mester warned against “declaring victory over the inflation beast too soon” and that “we need to raise interest rates from where they are now”.
Brainard suggested interest rates will stay high for a long time because “we’re at it for as long as it takes to bring inflation down.” In addition, “monetary policy needs to be tight for some time to build confidence that inflation is nearing target”.
Daly (President of San Francisco) noted that the Fed is trying to orchestrate a “slowdown” and by raising interest rates the Fed is “bringing back price stability, slowing the job market, slowing the housing market, slowing the growth of the economy, but do it a path that still allows us to move forward.”
September 8th – Powell (Fed Chair) committed to further aggressive action in the near term, noting that “we must now act boldly and decisively as we have done hitherto”.
Bullard (President of St. Louis) said in an article published on the St. Louis Fed’s website that “bringing today’s inflation rate back to that 2% target is the top priority for the FOMC.”
Evans (Chicago President) argued, “I think we have a good plan. We could do that very well [75-bps] in September”, but “I haven’t decided yet. I know we need to raise interest rates to much higher levels than now.”
Bullard commented that after August’s US jobs report, he is poised for a 75 basis point rate hike at the September Fed meeting.
Waller (Fed Governor) said: “The case for further unwinding of monetary accommodation remains strong.”
Markets discounting varying degrees of hawkishness
We can use Eurodollar contracts to gauge whether a Fed rate hike is priced in by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. Chart 1 below shows the difference in the cost of borrowing – the spread – for the front month/September 2022 and December 2022 contracts to give an indication of where interest rates will be headed by the end of this year.
Eurodollar Futures Contract Spread (September 2022-December 2022) [BLUE]US 2s5s10s butterfly [ORANGE]DXY index [RED]: Daily Time Frame (September 2021 to September 2022) (Chart 1)
September has so far been characterized by rapidly increasing chances of the Fed raising interest rates. On August 1, a 25 basis point rate hike was priced in by the end of 2022, with a 34% probability of a second 25 basis point rate hike (totaling 50 basis points by the end of the year). Now 100 basis point rate hikes are fully discounted, with a 4% probability of a fifth 25 basis point rate hike.
To some extent, the market is suggesting that the Fed’s final rate hikes could come in the coming months – with the bulk of the tightening effort arriving this week, with a 75 basis point rate hike being the base case. Given the outside chance of a 100 basis point rate hike, should the Fed deliver 75 basis points and not offer hawkish forward guidance, the September Fed meeting could turn into a “buy the rumour, sell the news” event for the US develop dollars .
Continue reading: How will markets react to the September Fed meeting?
Federal Reserve Interest Rate Expectations: Fed Funds Futures (September 20, 2022) (Table 1)
As has been the case for several weeks, Fed fund futures remain more aggressive than Eurodollar contract spreads in the near term. Rates markets see a 118% chance of a 75 basis point rate hike in September (a 100% chance of a 75 basis point hike and a 18% chance of a 100 basis point hike), with additional 50 basis point hikes in full Scope reduced in November and December. In the run-up to the economic policy symposium in Jackson Hole, the key interest rate should rise to 3.552% by the end of 2022; it is now discounted at year-end at 4.208% (currently 2.50%).
IG Client Sentiment Index: USD/JPY Rate Prediction (20 Sep 2022) (Chart 2)
USD/JPY: Retail trader data shows 29.49% of traders are net long, with trader shorts to longs ratio at 2.39 to 1. The number of traders net long is 6.82% higher than yesterday and 42.68% higher than last week, while the number of traders net short is 0.16% lower than yesterday and 4.37% higher is higher than last week.
We usually view crowd sentiment as contrarian and the fact that traders are net short suggests that USD/JPY rates could continue higher.
Still, traders are less net short than yesterday and compared to last week. Recent sentiment changes are warning that the current USD/JPY price trend may soon reverse to the downside, although traders remain net-short.
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— Written by Christopher Vecchio, CFA, Senior Strategist