Fed Pledges to Keep Hiking Rates While Long-Term Treasuries Signal Recession Risks

The Fed raised interest rate by 25 bp, but made it clear that the policymakers are not going to stop and will deliver additional six more rate hikes this year. In addition, the Fed raised the level of terminal rate, at which the tightening cycle will end – up to 2.8%. Geopolitical tensions are creating more uncertainty, despite that the Fed, according to Powell, is committed to fighting inflation. The communicated stance of the Fed implies that balance sheet runoff should start as early as in summer.The Fed picked the pace of tightening that was almost fully in line with expectations, so the meeting fell short of bullish USD expectations. Markets price in gradual decrease in geopolitical risks so investors are gradually “setting off from safe havens” – US bonds and search for yield outside the US economy. As a result, the dollar remains under moderate pressure.The FOMC member Bullard suggested to move with 50bp hike. His position is clear – the economic growth rate is decent and inflation is at a 40-year high. Therefore, there is a need to act.However, the Fed has also made it clear that it is deeply concerned about situation in Ukraine and its economic implications, which means the risk that the Fed will eventually deviate from its rate hike forecast is higher than usual. If Ukraine and Russia come to an agreement before May, markets will likely price in an increase in the Fed rate by 50 bp. This may well become a driver for USD rally. In addition, if inflation continues to rise, exceeding 8%, then there is a risk that inflation expectations will take on a life of their own – greatly complicating the implementation of the Fed policy. In this case, the Fed may start raising rates to the detriment of economic growth.Of course, there are no guarantees that negotiations will end successfully. Also, restoration of supply chains is complicated by China’s costly strategy in terms of economic costs to fight covid. It is also unclear whether the balance between demand and supply for labor will be restored in the US in the short-term and how prices for commodities and, in particular, for oil will continue to change. Therefore, the Fed’s forecasts for the rate path this year should be taken as preliminary, the risk of their adjustment is high.The Fed’s strategy to sell assets from its balance sheet will also have a serious impact on the market, but the first details on it will likely appear in one of the summer meetings, so information on the Fed’s policy is currently incomplete.Short-term Treasuries reacted to the Fed meeting with decline in price, the yield of 2-year Treasuries rose to 2%. At the same time, 5 and 10-year long-term bonds rose in price. The continued inversion of the yield curve may indicate that market participants believe that the Fed’s hawkish policy will eventually lead to depression or recession and successive rate cuts, which implies that the cash flow value of long-term bonds should be higher. By the way, such reasoning underlies the popular relationship between yield curve inversion and expectations of a slowdown in economic growth.The spread between the yields of long-term and short Treasuries resumed decline after the Fed meeting, dropping to the levels preceding the pandemic: Despite the fact that USD weakened after the Fed, the medium-term consequences, in my opinion, are positive for the US currency. The main upside potential for the dollar is against the currencies of countries that import fuel and which are still limited in their ability to tighten policies. Among them are JPY, as well as EUR, which are currently recovering on expectations of a ceasefire in Ukraine. However, the medium-term effect of the price shock on the oil and commodity markets in general has yet to manifest itself.

Source: Tickmill