The U.S. Federal Reserve hiked its benchmark interest rate by 75 basis points (bps) for the third consecutive time, reaffirming its commitment to rein in inflation. Fed Chair Jerome Powell repeated the hawkish message he delivered at Jackson Hole last month: The central bank will continue tightening policy until inflation decelerates convincingly toward its 2% target — and the bar is high for this path to change.
“Restoring price stability will require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy,” Powell said this week. “We have got to get inflation behind us. I wish there were a painless way to do that. There isn't.”
Stocks fell after the Fed’s announcement, with the S&P 500 Index closing down 1.7%.
This comes after the August consumer price index (CPI) report dashed hopes that inflation was coming under control and reinforces the notion that Fed leadership intends to push its policy rate into restrictive territory. For historical context, in monetary cycles prior to 2000, the Fed raised rates until real policy rates were hundreds of basis points above zero.
Here are the latest views from fixed income portfolio manager Tim Ng and investment director Margaret Steinbach on the U.S. economy as well as positioning fixed income portfolios in this environment.
High inflation is broad-based
Our base case is that financial conditions are likely to tighten further as the Fed continues to aggressively raise rates to fight inflation. Given current valuations, however, our rates team members have added duration in the portfolios they manage to move from underweight toward neutral.
The fed funds terminal rate was priced around 4.4% following the August CPI report. The Fed’s new “dot plot” shows central bank officials believe the fed funds rate could reach 4.6% in 2023. Risks to duration feel balanced at these valuations, considering persistent inflation and downside risks to growth from tighter financial conditions.
Members of our rates team continue to hold Treasury Inflation-Protected Securities (TIPS) in the portfolios they manage, given their appealing valuations. We believe market expectations for future inflation are too low.
Yield curve steepeners (which benefit when the difference between long- and short-term interest rates increases) appear attractive, given the current entry point. We see the potential for asymmetric risk-reward with this position, given little room for further flattening and potential for meaningful upside if economic growth slows or if the Fed under-delivers on the market’s expectation for rate hikes.
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