Fed's Hiking Cycle Set to Begin

The are several high-frequency data points that often provide trading fodder for short-term participants, including US PPI, retail sales, industrial output, and housing starts. The eurozone sees January industrial production and trade figures. Japan is good for February trade and CPI. China gives February readings on retail sales, industrial output, employment, and investment. However, central bank meetings take up the oxygen: the Federal Reserve, the Bank of England, and the Bank of Japan.   Two emerging market central banks meet that will also draw attention:  Turkey and Brazil. 

Federal Reserve:   There are three dimensions to the FOMC's decision. First is the rate hike; the tightening cycle will commence. A 25 bp move has been well-telegraphed. Before the US warning on February 11, the market had discounted an 80% chance of a 50 bp move. We are not convinced the Fed's leadership was there in the first place, but it is clear it is not now. That said, Chair Powell is preserving maximum operation and explicitly did not take 50 bp moves off the table in this cycle. The Fed funds futures strip reflects this. The FOMC may not deliver the 100 bp of hikes the hawks want in the first half, but the market has it priced in by the end of July. 

Second is the forward guidance about its balance sheet. Powell seemed to suggest in his recent congressional testimony that some more details about its strategy will be represented. In any case, it seems likely the Fed will take the passive approach and allow the balance sheet to shrink, which means extinguishing some reserves by not reinvesting all of the maturing proceed. Logan, who runs the Fed's market operations, said recently that the principal Treasury payments (maturing issues) range from about $40 bln to $150 bln a month over the next few years and average about $80 bln. At the same time, there is an average of around $25 bln of MBS, also maturing a month for the next few years.  

Third is the Summary of Economic Projections, the dot plot. The individual projections for the Fed funds target rate draw the most attention. In the middle of December, 10 of the 18 officials expected that 75 bp in hikes would be appropriate this year. Another five were looking at 50 bp. There was one dove that thought a single rate hike should be delivered this year. The two most hawkish "dots" anticipated 100 bp tightening.  

Consider too the terminal rate. In December, five officials expected that the Fed funds target at the end of 2024 would be above where the median viewed at the long-term equilibrium rate of 2.5%. The median is likely to rise by 50 bp and maybe 75 bp this year. Recall that before the virus hit, the Fed had cut rates three times to 1.50%-1.75% (June, July, and October). The swaps market the Fed front loading tightening and peaking around 2% by late 2023.  

Lastly, be aware that at the conclusion of recent meetings, the equity market has initially rallied on the statement. However, the market has reversed lower during Powell's press conference recently. He appears to sound more hawkish than the statement. We are not convinced this is the case. It seemed a bit more like a Rorschach Test of Powell's pursuing maximum operational flexibility. The Chair has also recognized weaker growth in Q1 after an inventory-led 7.1% fourth-quarter surge. Like Q3 21 (growth slowed from 6.7% to 2.3%), the Q1 slowdown is likely not a prelude to another weaker quarter. Instead, growth is expected to be 3.5%-4.0% in Q2 before slowing in H2 to around 2.7%, according to the median forecast in a Bloomberg survey. The downside risks appear to be growing.  

Bank of England:   The most likely scenario is that the Bank of England delivers a 25 bp hike on March 17.   On the eve of the US warning that Russia was poised to attack Ukraine, the swaps market had a little more than a 60% chance of a 50 bp hike. The odds gradually fell, and at one point, earlier this month, the market even questioned a 25 bp hike. The MPC vote was 5-4 in favor of 25 bp in February, with Governor Bailey casting the deciding vote. The market has a little more than 130 bp in hikes discounted over the next six months. After that, the swaps market has about 40 bp of tightening before peaking.  

The BOE's balance sheet is set to shrink this month as a GBP28 bln maturing holding will be not reinvested. When the base rate gets to 1.0%, probably in May, the BOE could begin reducing the balance sheet by divesting its holdings. However, officials do not appear to have a sense of urgency about taking the more active route. Indeed, with the rise in energy prices, and inflation more broadly, the increase in NHS taxes (April 1), and rapidly rising rates (without long-term fixed-rate mortgages), the economy will be strained to the possible breaking point. Chancellor Sunak's Spring Statement (March 23) will be delivered amid increasing doubts the fiscal rules will be respected in fact. 

The UK will report February employment figures and January earnings data a couple of days before the BOE meets. Three-month average earnings growth (year-over-year) has been halved since peaking at 8.8% last June. It had fallen to 4.2% in November before ticking up to 4.3% at the end of 2021. Consumer prices rose 5.5% in January and are still accelerating sharply. Real earnings growth is collapsing. It is reasonable to expect that consumption will not be far behind. And the Tories seemed vulnerable going into the May local elections even before the marked economic deterioration took place.   

Bank of Japan:  Around the time the Bank of Japan meeting gets underway on March 17, the February CPI will be reported. Headline inflation will be boosted by the surge in energy and food prices. After a 0.5% year-over-year increase in January, an acceleration to 1.0% should not surprise. The core measure, which excludes fresh food prices, is also set to jump from January's 0.2% pace to 0.5%-0.6%. The real inflationary impulse comes from excluding fresh food and energy. It most likely will remain well below zero after the -1.1% January reading.  

In April, there will be more upward pressure on core measures as mobile phone charges that were cut sharply last year drop out of the 12-month comparison. This could be particularly sharp and has the potential to lift the headline CPI measure more than a full percentage point. While there may be little for the BOJ to do or say, Governor Kuroda could get ahead of it; by acknowledging (take away or minimize the element of surprise) and explaining why it won't by itself distract the central bank from its course. 

Last month, the BOJ showed that it was willing to defend the 25 bp Yield-Curve-Control cap on the 10-year yield. The bond-buying seen since the war broke out pushed the yield a little through 0.15%. The market is likely to re-challenge the BOJ resolve within the context of rising global rate and acceleration of headline inflation. Meanwhile, political (upper house election in late July and approval rating of the government is low) and economic considerations suggest that Prime Minister Kishida could cobble together a new spending bill, even if it re-allocates and re-prioritize unspent funds from past budgets. 

Brazil and Turkey: 

Banco do Brasil meets on March 16. The economy grew by 0.5% in Q4 21, a bit better than expected, and follows two quarters of small contractions. Still, the economy looks fragile at the start of this year. The manufacturing sector, in particular, looks softer. The manufacturing PMI was below the 50 boom/bust level for the fourth consecutive month in February, and industrial output fell 2.4% in January, the largest decline since March 2021.  

The Brazilian real is the strongest currency in the world here at the start of 2022, up 10%. Its strength seems to stem from two considerations. First, it is experiencing a favorable terms-of-trade shock as the price of foodstuffs and industrial commodities surges. The rolling 12-month average trade surplus is around $1 bln a month greater than a year ago. Second, the high-interest rates and commodity exposure are attracting foreign portfolio investment.

The central bank has been one of the most aggressive in lifting rates. The Selic rate began last year at 2.0% and finished at 9.25%. The pace of the hikes began at 75 bp in March through June 2021(three times) and increased to 100 bp moves (twice) in Q3. The pace accelerated to 150 bp in Q4 21 and February (three times). The Selic rate sits at 10.75%. IPCA inflation is near 10.50%.   Most look for a 100 bp increase at this week's meeting. The swaps market now sees the peak in the Selic later this year, near 13.5%. 

Turkey's central bank meets on March 17. It is unlikely to change its 14% one-week repo rate. The surge in energy and food prices present new challenges to the beleaguered Turkish economy. Inflation is already near 54.5% (core 44%).  The lira is off about 9.75% so far this year and probably needs to fall by 4.0%-5% a month to offset the inflation differential. Or, to say the same thing, with a nominal depreciation of less than 5%, the lira would appreciate in real terms. At the same time, higher food and energy prices will weaken growth even as it boosts inflation, and the weaker lira exacerbates the price pressures. It is caught in a vicious cycle, which would be challenging even for the best leaders with the strongest of institutions. Moreover, the beneficial impact on the external imbalance from the past depreciation of the lira will likely be offset by the surge in food and energy prices. Social tensions will likely rise.  

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