All eyes are on the three-day annual Fed conference at Jackson Hole, with the focus, particularly on Chair Powell’s speech on 26 August. Markets are going into this potentially pivotal event with expectations of hawkish Fed commentary as central banks worldwide remain focused on taming inflation running at multi-decade highs.
The two-month-long equity rally has stalled, with the S&P500 pulling back from its key 200-day moving average resistance, the 10-year US Treasury yield rising above 3% for the first time since mid-July, and the USD attempting to break out into a 20-year high.
Standard Chartered in its weekly market view commentary said it will watch out for three potential catalysts in Fed speeches that it believes are likely to set the tone for markets in the coming weeks and months:
Consensus among Fed policymakers for another 75bps hike in September. Market expectations are split between a 50bps and 75bps hike next month following mixed data: the US job market remains red-hot (jobless rate is at a 50-year low), which continues to fuel wages, consumption, and house rents. This week, durable goods orders data also suggested business spending remained healthy. However, policymakers will have to weigh that against a slump in business confidence (PMIs for August indicated a sharp contraction in US economic activity in Q3).
Meanwhile, housing markets continue to weaken as this year’s surge in mortgage rates starts to bite (July US house prices suffered their biggest m/m decline since 2011). Markets are not expecting the Fed to waver in the face of weaker PMI and housing data amid a tight job market, but this implies that any signs the Fed is considering softening its stance – by slowing the pace of rate hikes, for example – would likely boost risk assets in the near term.
Any rethink of the Fed’s 2.5% neutral policy rate estimate. After a scorching pace of rate hikes this year (225bps in five months), the Fed’s policy rate has risen to the estimated so-called ‘neutral’ 2.5% rate, beyond which any further tightening should theoretically start to make financial conditions restrictive and slow growth. The Fed currently projects a policy rate of 3.4% by end-2022 and 3.8% by end-2023, before rate cuts bring it down to 3.4% by end-2024. However, the continued strength of the job market and consumption, despite the policy tightening thus far, has raised concerns that the neutral rate and terminal (or end-of-cycle) rate could be higher than the Fed’s estimates. Any hint that Fed policymakers are considering an upward revision of these key rate estimates would risk a significant shift in market expectations, a scenario that could potentially push the USD above its 20-year high and the 10-year US yield beyond its 3.5% June peak, causing a near-term pullback in risk assets.
Any reassessment of the Fed’s long-term 2% inflation target. While this is arguably the least likely of the three, it is possible the Fed may consider raising its inflation target on the grounds that structural inflation has risen after the pandemic, especially amid concerns that globalisation is reversing. US CPI inflation, running at a 40-year high above 8%, is likely to slow in the coming months due to base effects as well as easing commodity prices and supply bottlenecks.
However, where inflation settles after peaking is more relevant, in our view. The Fed currently expects US core inflation (core PCE, one of the Fed’s preferred measures) to end 2023 at 2.7% and 2024 at 2.3% (vs. 4.8% in June). Given its 2% inflation target, these projections suggest the Fed would have to continue tightening its policy far longer than the markets currently expect (ie, early 2023), even if that leads to a sharp slowdown in growth. Any indication that Fed policymakers may be considering raising the inflation target to 2.5-3% is likely to ease investor concerns about an overly aggressive Fed policy in the coming months, a scenario that could cause the USD to pull back, the Treasury yield curve to steepen and global risk assets to rally.
