Fed hikes cash rate by 75bps, as widely expected. Updated 'dot plot' show +125bps of hikes over remaining two meetings this year. USD stronger on the day, although off its intraday highs as risk appetite rebounds

The FOMC meeting took place a short while ago, the Fed hiking by 75bps (as expected) and significantly revising up its interest rate forecasts.  The new ‘dot plot’ implies the Fed will raise rates by 75bps and then 50bps at its remaining two meetings of the year with a peak in the cash rate of 4.6% now projected for next year.  Markets are still in flux.  The initial reaction has seen a further flattening of the US yield curve (short-end rates higher, long-end rates lower).  Equities initially sold-off aggressively and the USD rallied sharply, although these moves have largely reversed over the past hour.  The EUR has been under pressure overnight after Putin’s threats of escalation in the Ukraine war while the NZD has recovered from fresh 2½-year lows to around 0.59.  The Bank of Japan and Bank of England are key central bank meetings ahead in the next 24 hours.

As widely expected, the Fed raised its cash rate by 75bps, to 3.0%-3.25%.  The market had placed an outside chance (~20%) on a 100bps move, but a 75bps hike was always seen as the much more likely option.

The Fed significantly lifted its interest rate projections from the so-called ‘dot plot’, reflecting a hardened resolve to get on top of inflation.  The median forecast for the end of 2022 is now up to 4.4%, 100bps higher than the June projections, implying a cumulative 125bps of hikes over the remaining two meetings of the year (likely 75bps + 50bps), although there were 8 (of 19) members in favour of 100bps.  The dots then show the cash rate nudging up to 4.6% for the end of 2023 (previously 3.8%), before dipping to 3.9% at year-end 2024 (previously 3.4%), and then 2.9% by the end of 2025.  Essentially, the Fed thinks it needs to take the cash rate into “sufficiently restrictive” territory over the next year or so but once inflation is (hopefully) under control, rates can return to more neutral settings.  Of course, as the past few years have starkly illustrated, forecasting inflation is a difficult business and the Fed’s interest rate projections are highly conditional on things evolving as they expect.  Time will tell.

There were almost no changes to the statement itself, but the updated economic forecasts show a bleaker, but potentially still-too-optimistic, economic outlook.  The economy is expected to skirt with recession this year (real GDP of just 0.2% y/y for 2022) while the central estimate of the unemployment rate is expected to now increase to as high as 4.4% (previously 4.1%).  Core PCE inflation is seen at 3.1% by the end of 2023, falling back to 2.3% the following year.

Powell has largely managed to stick to the hawkish script in the press conference so far, reiterating the message from Jackson Hole that the economy will likely need to see a sustained period of sub-trend growth (even he holds out hope that a recession can be avoided) and history cautions against easing policy too early, when inflation is this high.  Powell noted the Fed now saw the cash rate as having “moved into very lowest level of what might be restrictive and certainly in my view, and the view of the committee, there’s a ways to go.”  This might imply the Fed sees the shorter-run neutral rate closer to 3% than the 2.5% longer-run assumption.

The market has been volatile and in flux since the statement was released and Powell started speaking.  The initial market reaction had been as one would expect after a hawkish set of rate forecasts, with US bond yields sharply higher at the short end of the curve, the yield curve inverting further, equities markets coming under pressure and the USD surging further ahead.  But these moves have since largely reversed over the past hour, even though Powell hasn’t said anything obviously dovish.  One could argue the market was braced for a hawkish meeting, and it got what it expected.  Things could still change significantly over the coming hours and days.

The US bond market has had a ‘twist’ move, the US 2-year rate 6bps higher, at just above 4%, while the 10-year rate is 6bps lower, at 3.51%. As such, the 2y10y yield curve has inverted further, now around -52bps and near its lowest level since the early 1980s.  Expectations of the terminal Fed funds rate have shifted up around 5bps to 4.55% by mid-2023 but the market still prices aggressive rate cuts from the second half of next year.

Equities were immediately lower after the release of the Fed’s updated set of interest rate projections, the S&P500 down as much as 1.7% in the minutes that followed, but they have staged something a recovery over the past hour, the S&P500 and NASDAQ now back to flat on the day.

It has been a similar story in currency markets, the USD initially surging to fresh multi-year highs after the release of the updated dot plot, before reversing lower as equity markets recovered.  The USD is still higher on the day, by around 0.4%-0.5% on an index basis, although it is well off its intraday highs.

The EUR has been under pressure overnight, hitting a fresh 20-year low, on the risk of further escalation in the Ukraine war.  Overnight, Putin announced a ‘partial mobilisation’ of the population for the war in Ukraine, allowing for up to 300,000 reservists to be drafted up to join front-line forces.  The move takes place ahead of referendums starting this weekend in Russian-occupied territories in Eastern Ukraine, the end result of which will see Russia annex those areas.  Putin also implicitly threatened the use of nuclear weapons saying Russia would “use all the means at our disposal”, adding “this is not a bluff .”  10-year bond rates in Europe were down 3-6bps while the EUR has fallen below 0.99, almost 1% lower on the day.

The NZD and AUD hit fresh 2½-year lows in the aftermath of the Fed statement, but both have since recovered as risk appetite has improved.  The NZD gapped down to almost 0.5840 but it has since rebounded to around 0.5880.   The pullback in the 10-year US Treasury rate has seen the JPY recover as well, USD/JPY back to around 143.80, broadly unchanged on the day.

Turning to domestic developments, NZ rates had a big move higher yesterday, playing catchup to the overnight moves in global rates markets. The 2-year swap rate was 6bps higher while the 10-year rate up a chunky 10bps, at 4.23%. Government bonds outperformed swap significantly, with the 10-year yield up by 6bps, suggesting some demand may be returning to the NZGB market ahead of their impending entry to the World Government Bond Index (WGBI) on November 1st.  Yesterday’s steepening move should reverse today following the sharp flattening of the US curve post the Fed meeting.

The central bank action continues today, with four central banks stepping up to the plate.  The key meeting is likely the Bank of Japan one this afternoon.  The consensus is that there will be no change to policy this time despite the recent marked increase in underlying inflation and sharp fall in the JPY, with the BoJ to also retaining its easing bias.  There remains a tail risk that the BoJ could amend its Yield Curve Control policy, either increasing the allowance range above the 0% 10-year target, shortening the target bond to the 5-year tenor, or abandoning it altogether, but the thinking is this meeting comes too soon for such a change.  Any change to the BoJ’s Yield Curve Control policy would have major repercussions for both the JPY (stronger) and global rates (higher), given Japan’s importance as a major investor in global bond markets.

Tonight sees the Bank of England, Swiss National Bank and Norges Bank take place.  In terms of the BoE, the market is leaning towards a 75bps move while economists are more in the 50bps camp.  The BoE is also expected to rubber stamp the start of active sales of its large UK government bond holdings in the secondary market despite the forthcoming ramp up in issuance to finance Liz Truss’ energy price cap and other fiscal measures.  The Norges Bank is expected to hike by 50bps and the SNB by 75bps.  NZ consumer confidence and trade balance data is released this morning.