INTRODUCTION

The two-day FOMC meeting starts today and wraps up tomorrow afternoon. We expect a 25 bp hike and a very hawkish tone from the Fed. We also conduct a survey of past Fed policy cycles and conclude that an H2 easing cycle is very unlikely. With risks to U.S. rates weighted to the upside, the dollar is likely to benefit from any bond market repricing of Fed policy.

FED OUTLOOK

The narrative has shifted since the last FOMC meeting. Back in December, the Fed delivered a very hawkish tone in hiking rates 50 bp. Chair Powell delivered the hawkish goods, noting that the Fed sees inflation risks to the upside and that a restrictive policy stance will likely be needed for some time. Powell said the labor market remains out of balance and that “we have more work to do.” He stressed that the Fed would need “substantially more evidence of lower inflation” and that the Fed isn’t at a sufficiently restrictive stance yet and still has “some ways to go.” Since that meeting, retail sales have weakened substantially while most measures of inflation have eased, albeit to still-elevated levels. Below, we look at several moves that the Fed could make tomorrow and in the coming months. Updated Dot Plots and macro forecasts won’t come until the March meeting.

1. Hike rates 25 bp – VERY LIKELY. This is the safe choice and fully priced in right now. We see no need for the Fed to deviate from its more cautious path. However, the hard part for the Fed will be convincing the markets that it remains committed to fighting inflation by maintaining tight monetary policy. Looking ahead, WIRP suggests a 25 bp hike at the March 21-22 meeting is nearly 85% priced in, with no more subsequent hikes priced in.

2. Hike rates 50 bp – UNLIKELY. Given recent signs of softness in the real sector data along with continued disinflation, the need for a more aggressive hike has fallen. The centrist policymakers are currently in control of the narrative, displacing the hawkish wing led by Kashkari and Bullard. That said, there is a very small chance of a 50 bp move as a response to how loose financial conditions have gotten.

3. Keep rates steady – VERY UNLIKELY. Simply put, inflation remains too high for the Fed to take its foot off the brakes anytime soon. The labor market remains extremely tight and wage pressures remain higher than the Fed’s comfort zone.

4. Jawbone – VERY LIKELY. The Fed should leave the door wide open for further rate hikes and Chair Powell should stress that the Fed is prepared to continue hiking rates beyond 5% and keep them there until 2024, as the December Dot Plots showed. With the Fed likely downshifting again to a smaller rate hike, markets may mistakenly take this as a sign of weakness in the Fed’s resolve. The swaps market is pricing in a peak policy rate near 5.0%, which is lower than the latest Dot Plot. What’s worse, the market is pricing in an easing cycle in H2 while the Dot Plots suggest this is a 2024 story. Expect the Fed to push back against this notion.

ECONOMIC OUTLOOK

Price pressures are falling. December PCE data showed continued disinflation. Headline PCE deflator came in at the consensus 4.4% y/y vs. 4.7% in November, while headline came in at the consensus 5.0% y/y vs. 5.5% in November. Both are the lowest readings since late 2021 but still more than double the Fed’s 2% target. CPI and PPI are showing similar disinflation. As we’ve noted many times before, the easy part is getting inflation down from 8% to 4%. Getting it from 4% to the 2% target is the hard part and that is what we think markets are overlooking.

U.S. financial conditions continue to loosen. According to the Chicago Fed’s measure, financial conditions through January 20 were the loosest since March (since February for its adjusted measure) and are still falling. After 425 bp of tightening, this looseness is not something the Fed wants to see right now and so we expect Powell and company to deliver a very hawkish message tomorrow. This is especially true if the Fed downshifts again to 25 bp, which the markets will likely interpret as further signs of an eventual pause and pivot.

Q4 GDP data are worth discussing. Headline growth came in at 2.9% SAAR vs. 2.6% expected and 3.2% in Q3. Looking at the components, personal consumption came in at 2.1% vs. 2.9% expected and 2.3% in Q3. This isn't too surprising given the weak November and December retail sales. Investment came in at 1.4% SAAR vs. -9.6% in Q3, while government spending came in steady at 3.7% SAAR. Of note, all four major components of GDP contributed to growth, something we haven’t seen since 2019. However, one big negative here is that the volatile inventories component contributed 1.46 ppt, offsetting the -1.20 ppt subtraction from fixed investment. The Atlanta Fed GDPNow model reported its first estimate for Q1 growth at 0.7% SAAR. It does appear that the U.S. economy lost some momentum as we moved into the new year, as evidenced by weakness in the recent retail sales and IP data. However, Bloomberg consensus for Q1 growth of 0.1% SAAR seems too low.

December Chicago Fed National Activity Index shows the economy is growing below trend. This series has taken on greater significance now that the 3-month to 10-year curve has inverted deeply (see below). The headline came in at -0.49 vs. -0.51 in November. November was never released and so both months were reported at the same time. A zero reading means the economy is growing at trend and so there have been two straight months of significant below trend growth. The 3-month moving average came in at -0.33 vs. -0.14 in November and is the lowest since March 2020, when the pandemic hit. Recall that when this 3-month average moves below -0.7, it signals imminent recession and we are still above that threshold. That said, with the economy softening, it's only a matter of when, not if, the recession hits.

The U.S. yield curve is already signaling a strong chance of recession in the next 12 months. The 3-month to 10-year curve has been inverted since November and at -107 bp, it is the most inverted since the early 1980s. While recession seems inevitable, we await confirmation from the CFNAI.

INVESTMENT OUTLOOK

We believe the dollar is in the process of carving out a near-term bottom. While down nearly 11% from the September peak near 114.778, DXY has seen some support emerge just below 102. If it can establish a good base at current levels until the Fed narrative shifts again, the dollar would be well-positioned to fist challenge the January high near 105.631. Of note, the euro has so far been unable to move much above $1.09 while sterling remains stuck below $1.25. USD/JPY is the wild card. This pair is vulnerable to renewed selling if the Bank of Japan starts removing accommodation this year, as we expect. However, the pace of tightening would be very modest and so further yen gains beyond the knee-jerk reaction will be tough.

Hawkish Fed messaging should help boost yields and the dollar. However, we note that the dollar tends to weaken on FOMC decision days. In 2020, DXY weakened on nine of ten decision days. In 2021, DXY weakened on five of the eight decision days. In 2022, DXY weakened on six of the eight decision days. This is particularly surprising given the hawkish stance in the Fed last year.

Equity markets are currently priced for perfection. A soft landing is being mentioned with increasing frequency, which means the Fed would not have to hike rates as much as feared. Where does the likely wake-up call come from? It could be much weaker U.S. economic data, which in turn would cast doubt on a somewhat rosy earning outlook. Or it could be significant repricing of Fed tightening expectations. Most likely, it will be a combination of these factors, which in turn are intertwined. Either way, equity markets seem ripe for a correction given the recent buildup in overly optimistic sentiment.

Bond yields seem too low. The 2-year yield is trading near 4.21%, up from the January low near 4.03%, while the 10-year yield is trading near 3.53%, up from the January low near 3.32%. If Fed expectations move higher, the 2-year yield should follow. The long end is a tougher call but we think that the recent move below 3.5% in the 10-year was overdone and see it trading in the 3.5-4.0% range in H1. We believe U.S. yields should move higher if and when a more hawkish narrative is established. In turn, this should help the dollar recover some ground.

A BRIEF HISTORY LESSON

Here is a chart showing Fed policy dating back 30 years to 1993. One can easily see the ebb and flow of monetary policy and inflation over the long run. However, we break this entire graph up and isolate each Fed policy cycle. This exercise will allow us to study the past several Fed tightening cycles in order to gauge how quickly the central bank has gone from tightening to easing in the past, and whether that can be repeated in this current cycle. In the breakdowns, we’ve included the entire tightening and easing cycles in order to better portray the scope of the Fed’s moves. We’ve also specified what the various inflation readings were at the start of the easing cycle and concluded that an H2 easing cycle is very unlikely.

1. Started tightening February 1994, stopped February 1995, started easing July 1995 with a 25 bp cut (2 meetings in between)
Inflation at start of easing: CPI was 2.8%, core CPI was 3.0%, PCE was 2.0%, core PCE was 2.0%
“As a result of the monetary tightening initiated in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions.” Rates went from 6.0% to 5.25% in the ensuing easing cycle. The Fed cut because the economy was slowing in response to its 1994-1995 tightening cycle.

2. Started and ended tightening March 1997, started easing September 1998 with a 25 bp cut (11 meetings in between)
Inflation at start of easing: CPI was 1.5%, core CPI was 2.5%, PCE was 0.6%, core PCE was 1.2%
“The action was taken to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies and of less accommodative financial conditions domestically.” Rates went from 5.5% to 4.75% in the ensuing easing cycle. The Fed cut in response to concerns about negative spillovers from the Asian Crisis as well as financial stability concerns after the collapse of Long-Term Capital Management in September 1998.

3. Started tightening June 1999, stopped May 2000, started easing January 2001 with a 50 bp cut (5 meetings in between)
Inflation at start of easing: CPI was 3.7%, core CPI was 2.6%, PCE was 2.7%, core PCE was 1.9%
“These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power. Moreover, inflation pressures remain contained.” Rates went from 6.5% to 1.0% in the ensuing easing cycle. The Fed first cut in response to the negative spill over from the Dot Com crash in March 2000, and then continued cutting rates after the terrorist attacks in September 2001.

4. Started tightening June 2004, stopped June 2006, started easing September 2007 with a 50 bp cut (9 meetings in between)
Inflation at start of easing: CPI was 2.8%, core CPI was 2.1%, PCE was 2.5%, core PCE was 2.1%
“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time. Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.” Rates went from 5.25% to 0.25% in the ensuing easing cycle. The Fed first cut in response to the negative spill over from the housing sector crash in early 2007, and then continued cutting rates due to financial stability concerns stemming from the sub-prime crisis.

5. Started tightening December 2015, stopped December 2018, started easing July 2019 with a 25 bp cut (4 meetings in between)
Inflation at start of easing: CPI was 1.8%, core CPI was 2.2%, PCE was 1.5%, core PCE was 1.7%
“In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent.” Rates went from 2.5% to 0.25% in the ensuing easing cycle. The Fed first cut in response to the negative spill over from President Trump’s trade wars and then continued cutting rates after the pandemic hit in early 2020.

In the last five turns between a tightening cycle and an easing cycle, the number of meetings in between ranged from 2 to 11, with an average of 6. Let’s assume that the Fed hikes tomorrow and at the March 21-22 meeting. If (and this is a mighty bog if) the Fed then ends the cycle, 6 meetings in between would suggest the first rate cut comes next year at the January 30-31 meeting. While this past experience tells us that a Fed easing cycle could theoretically begin as early as H2, it still seems unlikely. Like most Fed-watching these days, this is just an educated guess and circumstances will change as the year progresses. If the Fed extends the tightening cycle beyond March, as we expect, then the likely start of easing gets pushed further into 2024. Lastly, we note that the most recent inflation readings for December are as follows: CPI was 6.5%, core CPI was 5.7%, PCE was 5.0%, core PCE was 4.4%. At the start of all five previous easing cycles, inflation was never as high it is currently. For comparison’s sake, the highest readings were for the easing cycle that started January 2001, when CPI was 3.7%, core CPI was 2.6%, PCE was 2.7%, and core PCE was 1.9%. We’re not even close to that now, which makes an H2 easing cycle even less likely.