With A Week Until Next Fed Meeting, 75bps Hike Expected

After the shock of higher than expected June inflation, there was a strong suspicion that the Fed might move rates up a full one percent, or four times their typical level of rate adjustment. Now markets have backed away from that view, thinking that a 75bps move in rates is the most likely outcome when the Fed meets next week, with a 100bps move not completely off the table, but less probable.

Is Inflation Softening?

The Fed clearly wants to get inflation under control as is their mandate. There are some, early signs that might be happening as commodity prices, including energy, have generally weakened since mid-June and the strong dollar is driving down the price of imports. The housing market too, may be beginning to soften based on some early data. Still with 9.1% inflation for the year ending June 2022, and June itself seeing a big month-on-month move, it’s hard for the Fed to be complacent about inflation. Also, though inflation may come down, there is some debate over where it will settle, with the Fed targeting 2%.

Recession Risk

Ideally the Fed would like to tame inflation without harming the broader economy. That’s a tall order. The yield curve is now inverted, with short yields rising above medium-term yields on government debt. For example, at the time of writing, 1 to 3 year yields are above 10 year yields for U.S. Treasury bonds.

Historically that indicator has meant a recession is coming within 18 months. In fact, we’ll learn if the U.S. is actually in a recession the day after the Fed makes its decision on rates next Wednesday, with the first estimate of U.S. Q2 GDP expected next Thursday. Some models have the U.S. slipping into recession already in 2022. However, though many now expect a U.S. recession, most expect it to be a little further out.

Further Moves

Then the overall trajectory for rates is more important than the expected move at any single meeting. The Fed is expected to move rates up to around 4% by year end. With no scheduled meetings in August or October, the Fed will have 3 meetings left in 2022 to get that done. Though of course the could always adjust rates outside of their meeting schedule if they wish.

The market’s current view is that the Fed may be less aggressive in hiking in the fall, with perhaps one more 75bps move coming and then moving back to 50bps or even 25bps increases. The market suspects that the Fed may become increasingly concerned about recessionary risks, and either hold rates steady or make smaller movements come December and into early 2023.

So the market expects a big, inflation-busting hike next week, and perhaps another after that in September. However, then either moderating inflation or rising recessionary risks may cause the Fed to be more dovish in the view of the bond markets.