The market has a consensus that the Federal Reserve will raise interest rates by 50bp at the interest rate meeting in May 2022 and announce that it will start to shrink its table in June. Given that this meeting does not contain economic forecast data, the focus of the market is on the signal of the Federal Reserve on the tightening path. We briefly summarize the following three questions:
First, will the interest rate increase be accelerated to a neutral interest rate? Anchoring a neutral interest rate of 2.25% - 2.5% is the consensus of Fed officials. The dove Brainard, Daley and the hawk Meister have all expressed their support for raising interest rates to a neutral interest rate. However, if the wording of Powell's post meeting press conference changes hawkish, for example, the expression of raising interest rates to neutral interest rates as soon as possible changes from "toward neutral" to "to neutral", it means that the Fed may still maintain the rhythm of raising interest rates of 50bp after June, reach the neutral interest rate faster, and provide space for raising interest rates to exceed the neutral interest rate within the year.
Second, will the rate increase in the future rise to 75bp? Some hawks represented by Brad do not rule out the possibility of raising interest rates by 75bp at the follow-up meeting. The pressure of wage inflation remains unchanged, or more officials will join this camp. The last interest rate increase of more than 50bp was in 1994. If the market pricing refers to the policy style at that time, that is, the interest rate is 100150bp higher than the neutral interest rate, the final interest rate may rise to 3.5% - 4%. In the follow-up, we should be vigilant against the risk of double killing of stocks and bonds caused by large-scale and fast-paced interest rate hikes.
Third, how to shrink the table? We expect that the Federal Reserve will provide detailed guidance on the scale reduction at this meeting, and adopt the passive scale reduction mode from June to reduce US $60 billion of US Treasury bonds and US $35 billion of MBS per month. However, in consideration of policy flexibility, the Fed may retain the option to sell MBS, but will avoid selling Treasury bonds.
We expect that the interest conference in May will show "hawks crush and doves defecte!" So how far can the radical shift of Fed tightening since March go? We think there are three clues to be observed in the future:
First, inflation expectations. As shown in Figure 2, despite the rapid rise of real interest rate under the radical expectation of interest rate increase, there has been no significant suppression of inflation expectation so far. As the Fed believes that the risk of inflation is imminent, the Fed will think that tightening will have an effect only if the rise of interest rates brings the fall of inflation expectations in the future.
Second, financial conditions. Powell stressed at the March meeting that the financial conditions will shift to a more normal environment in the process of tightening the Fed's policy. From the current point of view, although the financial conditions in the United States have been tightened, they are still relatively loose compared with the environment after the financial crisis, which also means that the Fed can tolerate further stock market correction and dollar appreciation in the future policy tightening.
Third, wage inflation. With the rise of inflation expectations, the Fed has been worried about the wage inflation spiral. From the Fed's preferred wage index, the newly released first quarter labor cost index (ECI) grew by 1.4% month on month, the highest since 1990, which also shows that the existing tightening has not restrained the transmission of wages to inflation.
The key transmission channel of the Fed's tightening is financial conditions. Taking history as a mirror, in order to curb high inflation, the financial conditions index may need to return to above 100, which is not an easy target. The US financial conditions index hit a low (96.9) in November 2021. Since then, the US dollar index has appreciated by more than 10%, and the yield of 10-year US bonds has risen by more than 150bp. The index reached the level of 98.9 in early May 2022.
From the perspective of detailed items, the US dollar "has taken too big a step", while US stocks have obviously "lagged behind". The rise of the US financial conditions index above 100 means that the index has returned to at least twice the standard deviation of its average since 2000. We use this criterion to consider each sub index. As shown in figures 5 to 9, the financial condition index mainly includes the US dollar index (generalized weighting), the federal fund target interest rate, the S & P 500 index (adjusted by EPS), the credit spread of BBB non-financial enterprises and the yield of 10-year US bonds.
From the historical level, the US dollar index has made a clear jump and has exceeded the level of double the standard deviation. In addition to the tightening expectation of the Federal Reserve, the Russian Ukrainian conflict has contributed to the impact on Europe and the outbreak of the "currency war" in Asia. Followed by the yield of 10-year US bonds, which has risen sharply since the end of 2021 and is close to the average level. However, the Fed's interest rate hike and the adjustment of the stock market still lag significantly behind the average level. With the Fed accelerating interest rate hike and table contraction, the adjustment of US stocks is far from over.
The sharp adjustment of the U.S. credit bond market led to the continued sharp decline of U.S. stocks, which may mean that the tightening entered the second half. From the previous experience of tightening financial conditions in the United States, it is often divided into two stages: in the first stage, the rise of US dollar index and US bond yield are the main engines; In the second stage, with the sharp adjustment of credit bonds and US stocks, the tightening entered the sprint stage. As shown in figures 10 and 11, the U.S. credit bond market is an important thermometer of U.S. stocks and often leads the adjustment of U.S. stocks. Since 2022, the U.S. credit spread has been the first to expand. The resulting deterioration of corporate fundamentals and the rise of stock repurchase financing costs will become an important medium and micro catalyst for the decline of U.S. stocks.
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