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The Tug-of-War Continues: Hawkish Fed vs Recession

Global investors are now contemplating the fallout from US Fed rates reaching 6% after Powell's speech before the Senate Banking Committee on Tuesday.

Photo by Mathieu Stern / Unsplash

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As the Federal Reserve slowed the pace of interest rate hikes less than five weeks ago, US Federal Reserve Chair Jerome Powell issued a warning on Tuesday that it may need to re-accelerate.

On February 1, Powell said he could now claim that the "disinflationary process" had begun. On February 10, however, at a congressional hearing, Powell gave quite a different message.

Powell told the Senate Banking Committee, "the latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated."

"If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes," he added.

Callie Cox, an investment analyst at eToro, in North Carolina, United States said, "Powell just said the quiet part out loud. The economy is performing impressively well, but that could complicate the Fed’s efforts to bring inflation down."

"Therefore, the Fed could accelerate rate hikes and hike more than expected to bring inflation down. This isn’t surprising news, but it’s a tough reminder for markets after such a brisk rally," added Cox.

Related: Fed Chair Warns on Crypto Industry, Current Crisis

6% Fed rate?

Global investors are now contemplating the fallout from US Fed rates reaching 6% after Powell's speech before the Senate Banking Committee on Tuesday.

The potential for US interest rates to peak at 6% is sending shockwaves across the financial system, as more and more investors consider the consequences for various asset classes.

In a research note on Tuesday, Rick Rieder, chief investment officer for global fixed income at BlackRock, said, "We think there’s a reasonable chance that the Fed will have to bring the Fed Funds rate to 6%, and then keep it there for an extended period to slow the economy and get inflation down to near 2%," referring to the robust job market and sticky inflation.

Funds are thinking about this possibility after Fed Chair Jerome Powell said that the government might have to act more forcefully than was thought before to stop prices from going up.

"Powell was clear in his speech that rates need to rise higher and we cannot discount a peak above 6% given that inflation shows no signs of abating and growth indicators, if anything, are pointing to healthy status at the moment," said a chief investment officer at a large asset management firm in Boston.

A repricing of US rates and a surge in the dollar followed the comments, while digital assets, stocks, and emerging market currencies fell.

Recession Fear Returns From Powell's Jolt

Bets on future Fed rates went up after Powell's shock, which was a rude awakening for investors on Wall Street. It made them worry about a recession and crushed the riskier parts of the market, especially cryptos and related assets.

"By signalling a return to a half-point walk, Powell has put the Federal Reserve at odds with several of its peers, who are poised to cease their tightening efforts," noted a fund manager at a boutique investment firm in Washington.

"Bond prices are signalling the increasing likelihood of a recession, and Friday's non-farm payroll data may now be pivotal in determining the direction of market sentiment," added the fund manager.

The bond market has priced in a higher chance of a recession because the Fed might have to raise interest rates again to slow down inflation and the economy.

Indeed, two-year rates on U.S. Treasury bonds jumped above 5% for the first time since 2007.

Futures trading shows that a rate increase of 50 basis points is more likely than a rate increase of 25 basis points, which was the size of the Fed's last change, for the March 21–22 meeting.

Critically, longer-dated yields remained stalled, with the 10-year rate remaining under 4%, while 30-year bonds have barely budged since Friday.

Worryingly, the yield on US 2-year bonds was higher than that on US 10-year bonds by a full percentage point for the first time since 1981, when then-Fed Chair Paul Volcker was engineering hikes that broke the back of double-digit inflation at the cost of a lengthy recession.

Ken Griffin, the CEO and founder of hedge fund giant Citadel, says that a similar thing is happening right now.

"We have the setup for a recession unfolding" as the Fed responds to inflation, Griffin said in an interview in Palm Beach, Florida.

Inversions of the yield curve happen when short-term interest rates are higher than long-term rates. This is usually a sign that a recession is coming soon.

The Fed must raise interest rates even further, according to billionaire Ken Griffin, because "traumatic" levels of inflation have hurt American citizens and prepared the country for a recession.

The founder of Citadel and Citadel Securities argued that the central bank is limited in how much it can fight inflation, and he added that raising interest rates is like "having surgery with a dull knife."

On Wednesday, the repricing of US Fed rates was evident, with most Asian currencies and regional stock indexes down.

Brendan McKenna, an emerging markets strategist at Wells Fargo in New York, noted, "higher-for-Longer is becoming the base-case scenario, and if that scenario materialises, EM can suffer. Markets were really hoping for an early Fed pause and cut this year, but so far that scenario is not unfolding."

Is the Fed Behind the Curve?

The Fed slowed to a quarter-point clip last month, and Powell's latest shift might fuel doubts about whether the Fed was premature in doing so.

It would be the third strike against a Fed that misjudged how long-lasting price hikes would be a year ago and moved cautiously when first raising rates.

In 2021, the Fed called the rising inflation trend as "transitory."  

Nonetheless, authorities insist this recovery is exceptional, and that policy should reflect the facts.

Several senior market players were caught off guard by Powell's surprising and clear opening of the door to 50 basis points later this month.

That is, even as Powel has repeatedly said, the Fed needs to be flexible when making policy decisions because there is a lot of uncertainty about how long inflation will last.

Goldman Sachs Group raised its forecast for the Fed’s peak rate by a quarter point, to a range of 5.5% to 5.75%.

“We expect the data ahead of the March meeting to be mixed but firm on net, and we, therefore, see our standing forecast of a 25 basis point hike in March as a close call, with some risk that the FOMC could hike by 50 basis points instead,” Goldman Sachs economists wrote in a note to clients following Tuesday’s hearing before the Senate Banking Committee.

“We now expect that the median dot in the March Summary of Economic Projections will rise by 50 basis points to a peak of 5.5%-5.75% in 2023,” added the economists.

Analysts pointed out that Powell's announcement came after the departure of Lael Brainard, who was seen as an advocate of slower rate rises.

"When Lael’s Away the Hawks Will Play," Michael Feroli, chief US economist at JPMorgan Chase, said in the title of his research note on Powell’s testimony Tuesday.

Feroli said on Bloomberg TV that he hadn’t yet changed his call for a quarter-point March hike, but viewed it as tough for Powell to walk back his Tuesday message without the upcoming data being "not just in line, but weaker than expected."

The ongoing tug-of-war between the central bank's "hawkish" messages and the risk of a recession will make the financial markets, especially digital assets, which are in the middle of another crisis, more unstable.

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