Fed – Slower but higher
The Federal Reserve will hold its last FOMC meeting of 2022 on Wednesday, when it will also update economic projections.
Following a series of weak macro data and the soft inflation print in November, the Fed will slow down the pace of hikes from 75bp to 50bp, resulting in the Fed funds rate ranging from 4.25-4.50%. However, the central bank will guide for a higher terminal rate than previously indicated, likely closer to 5%, from current projection of 4.65%. Labour markets remain tight, but every other indicator points to an upcoming slowdown, therefore justifying a less hawkish stance.
Inflation forecasts are likely to be revised down and the Fed will need to recognize a mild recession for 2023. Markets will focus on the Fed’s own assessment of the unemployment rate as the key indicator for upcoming easier policy in case of a sustained slowdown.
Fed speakers have broadly delivered a softer message, demonstrating more comfort with the latest inflation data. Chairman Powell stressed the importance of the ongoing fall in rent inflation data for future inflation at a recently held talk.
We continue to see a terminal rate close to 5% or slightly lower and potential for discussions around cuts in the second part of 2023. Lower commodity prices and an upcoming slowdown mean inflation will continue to drop, reaching 5% by summer 2023. We continue to believe the peak in US rates and the dollar has happened. For the most part, the market has priced in this scenario. That said, we see more upside, especially in FX and credit, given the amount of outflows seen in 2022 and current valuation levels.
ECB – Balancing act
On Thursday, the ECB must balance the necessity to slow down the pace of hikes due to economic weakness and inflation stability with the push from hawkish members of the Governing Council for a continuation of sustained hikes.
We think the balancing act may be a slowdown to a 50bp hike, taking the deposit rate to 2%, together with the start of quantitative tightening. Balance sheet reduction will probably be shallow and take place via asset shrinking by around EUR10-20bn per month; this is small compared to the $95bn per month adopted by the Fed. The central bank will likely implement the policy by avoiding APP re-investments.
Inflation forecasts are likely to drop meaningfully, as the last set of projections was released in September when gas prices were 30% higher. The latest print also provides some relief. We see the terminal rate for the ECB close to 3%, but with more upside risk vs the Fed given more negative real rates, more persistent inflation, and deeper splits within the Governing Council.
Algebris Investments’ Global Credit Team
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