Capital Ideas^™ 
Investment insights from Capital Group

The U.S. Federal Reserve delivered its second consecutive rate hike of 75 basis points (bps) this week, as the fight against inflation remains its primary focus. With the federal funds rate range now set at 2.25% to 2.5%, matching its peak from the last hiking cycle and in line with the central bank’s long-term estimated neutral rate, the question becomes how much further the Fed will go. 

Fed Chair Jerome Powell has signaled that the central bank will keep moving aggressively as long as inflation continues rising. However, it remains to be seen how the Fed would react if growth slows more meaningfully. Coming into the July 27 meeting, markets were pricing in a terminal rate (the point at which the Fed stops hiking) of around 3.5% and multiple rate cuts in 2023. Equity markets were boosted early Wednesday, after encouraging earnings reports from Microsoft and Alphabet, and remained strong following Powell’s press conference as he opened the door to slowing the pace of the hiking cycle.

“While another unusually large increase could be appropriate at our next meeting, that is a decision that will depend on the data we get between now and then,” Powell said. “At some point, it will be appropriate to slow down. … We've been front-end loading these very large rate increases, and now we're getting closer to where we need to be.”

Below, we provide perspectives from U.S. economist Jared Franz, and fixed income investment directors David Bradin and Margaret Steinbach.

• The Fed appears to be committed to fighting high inflation despite recent weakness in economic data. The Fed’s commitment to restoring price stability has not changed and, overall, we still believe that inflation concerns exceed growth concerns.

• We have seen weaker data in U.S. housing and eurozone manufacturing purchasing managers’ indexes (PMI), which moved into restrictive territory. This has led futures markets to pull down the terminal Fed funds rate for this cycle to below 350 bps and price in multiple rate cuts in 2023.

• Over the medium-term, uncertainty and volatility appear set to continue. Heightened geopolitical tensions, elevated commodity prices and ongoing supply chain disruptions will likely make it hard for the Fed to sustainably get inflation down below 2%, as it was before the great financial crisis. But high inflation is not likely to turn into hyperinflation.

• When the United States went into recession in 1980, Fed Chair and inflation hawk Paul Volcker cut rates substantially before raising them back up again. If inflation is persistent, Powell could look to follow a similar template.

• Overall, the U.S. economy looks strong relative to its peers. Countries like Germany, Japan and China have multiple structural weights on them, and the flexibility of the U.S. economy is still there.

• Core bond portfolios are positioned to be modestly underweight duration, which means they are less sensitive to interest rate moves than their benchmarks. The rates team believes markets are underestimating the potential for future hikes.

• Given current valuations, we expect yield curve steepening positions (which benefit when the difference between long- and short-term interest rates increases) to add value should the Fed need to temper the pace of its tightening sooner than expected.
  

• We believe Treasury Inflation-Protected Securities (TIPS) continue to offer attractive near-term carry (the return obtained from holding the investment) and have the potential to benefit amid rising medium- and long-term inflation expectations.
  

• In multi-sector fixed income strategies, portfolio managers remain underweight high-yield and investment-grade (BBB/Baa and above) bonds. Investment-grade spreads, which currently sit around 150 bps above U.S. Treasuries, and high-yield spreads of around 500 bps may not be fully reflecting the potential of an economic slowdown or outright recession.
  

• Multi-sector fixed income portfolios are positioned cautiously on credit and interest rates, and are underweight to both rates and spread duration. Portfolio managers tend to prefer securitized credit based on the strength of the consumer relative to corporates.
  

• Persistent inflation is creating higher input costs for companies, including labor costs, which is likely to put further pressure on profitability, cash flows and overall balance sheet strength. Over the past week, we have seen the first reports of companies reducing labor costs, including some large retailers and tech companies.
  

• In the high-yield sector, refinancing is low as a result of many companies issuing bonds at low rates in 2020. But as rates have gone up, further issuance might not be an option for some companies, should their fundamentals weaken.