Fed faces an ugly inflation outlook

Inflation in the US shows no imminent sign of slowing down with the May print of 8.6% y/y CPI an unwelcome read ahead of this week’s FOMC meeting. Markets had been primed for the Federal Reserve to hike the Fed funds rate by 50bps this week, along with another 50bps at the July FOMC, followed by 25bps hikes at meetings over the rest of the year. That has now shifted to a much more hawkish trajectory with the potential of a 75bps hike potentially in play or at least taking rates up to more than 3% by the end of 2022.

We maintain our expectation for 50bps at the FOMC this week as well as in July and now see a much stronger likelihood that the Fed will hike by 50bps at the September meeting as well in order to push back against inflation. That will have represented 225bps of hikes from the start of the year in conjunction with a faster pace of balance sheet run down than the Fed has carried out previously. We can’t rule out the possibility of the Fed using a 75bps hike to shock markets but the pass-through to consumer behaviour, particularly for services which appear to be the main inflation driver at present, is likely to be limited. Doing a 75bps hike now doesn’t preclude needing to use 50bps hikes later on and an increasingly expensive borrowing environment should help to quash inflation on a sustained basis over the next six to 12 months.

The June FOMC will also see the release of new economic projections. At the March meeting, the Fed projected GDP growth of 2.8% for 2022, sharply down from 4% in their December projections, and PCE inflation at 4.3%, up from 2.6% previously. We would expect to see a material increase in the inflation outlook given that the domestic drivers of price growth are entrenched while exogenous factors, like supply chain disruptions caused by China’s zero-Covid policy and a tight oil market thanks to the war in Ukraine, show no sign of easing.

With a 50bps hike seemingly set for September as well that brings our year-end expectation for the Fed funds rate up to 3% but again we note that risks remain to the upside given the Fed’s inflation challenge. Using a 75bps hike this week and 50bps hikes in September and November would mean we end the year with a Fed funds rate as high as 3.5%, its highest level since 2007.

Much more aggressive pricing of Fed hikes will invert the US Treasury curve again, and likely on a more sustained basis. At present the 2s10s spread is barely above 2bps compared with nearly 30bps at the start of June. Yields on the 2yr UST will keep wrenching higher as markets anticipate aggressive moves from the Fed and we now target a level of 3.3% on the 2yr by the end of the year. On the longer end of the curve, we still expect to see some moves higher in yields but by the end of the year yields will start to price in a more imminent downturn in the US economy and we now target a 10yr UST yield of 3.1%.

Emirates NBD Research fixed income assumptions

Source: Bloomberg, Emirates NBD Research