The Fed has the data to become more hawkish over the coming quarters … or even sooner

Published on June, 21th 2022Market and research
Flageollet

Stéphanie BIGOU

Portfolio Manager

Intended for Professional Clients in accordance with MIFID.

Written on 13 June 2022 by Seeyond.

Let’s look at the facts:

  • The best-known rule for determining the US policy interest rates is the one developed by John Taylor in 1993. In this paper, Taylor sets out a simple rule to model the evolution of Fed funds rates. What is the Taylor rule telling us today?
  • Historically speaking, Fed funds rates are very correlated to the Taylor rule.
  • The gap between the US official policy rates and the theoretical rates derived from the Taylor rule has never been so high. The last time it happened was in 2018 and 2019 when the Fed was hiking rates and reducing its balance sheet. At that time, the ratio between Taylor rule rates and US official policy rates was around 50%. The current period looks like 2018 and 2019 in terms of monetary policy, meaning that the Fed could hike rates till at least 50% of the current Taylor rule rate without being considered as too aggressive taking into account the current inflationary and growth environment. Thus, in theory, Fed fund rates could reach [4%;5%] in a near future if the current inflationary tensions do not ease quickly.

What do we think?

  • The last macroeconomic data are slowing down but suggest that the risk of an imminent recession in the US is low. Indeed,the pillars are strong: the labor market is solid ; wages growth is robust ; despite the increase in mortgage rates, housing prices are still increasing at an elevated pace ; corporate investment remains dynamic, still benefiting from post-covid public aid & investment plans ; industrial and service confidence indicators are peaking up ; consumer demand is robust ; corporate sector and households financial situation is healthy. Moreover the gradual reopening of China and the persistent tensions between Russia and Ukraine should prevent any sustained downturn in commodity prices, encouraging a wage-led inflationary spiral.
  • In this context, the Fed should have the opportunity to hike rates to level closer to the Taylor rule. At minima, pressures on Fed funds rates should remain on the upside for a while.
  • The markets anticipate Fed funds rates at 3.75% at the end of the tightening cycle. They could even be higher as shown by the Taylor rule. Such a surprise would be bad news for both bond and equity markets. As an example, in terms of valuation, all other things being equal, US 10-year rates at 4% goes hand in hand with an SP500 at 3500. Not sure if we have already seen the low point on equities in a medium term perspective!

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Source: Bloomberg, Seeyond – Data from January 1971 to end April 2022 – Monthly data

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