Andrew Pyle
May 04, 2022
Fed Up!
Hardly earth-shattering news, but the Federal Reserve decided today to raise it overnight target rate by half a percentage point to a 0.75% to 1% range. Its discount rate was also increased by the same amount to 1%. The rationale for the elevated inflation rate that has moved ahead of what the Fed believed less than a year ago. At the same time, the Fed also remarked about the heightened uncertainty surrounding the economic outlook from the Ukraine invasion and supply bottlenecks in China. Most market participants expected the FOMC to comment on the slowing in economic activity in the first quarter, but this was offset by strong employment. The other item that was largely expected was the start of the Fed’s unwinding of quantitative easing – or what is called “quantitative tapering”. This is going to start on June 1st at a pace of $47.5 billion per month. The maximum the Fed will sell off treasuries is $95 billion and only after three months.
This is the first time the Fed has lifted rates by 0.5% since 2000 and investors expect that this won’t be the last one. Back then, the half-point hike was the last of that cycle’s tightening program and coincided with the start of a 3-year decline in stocks. The important thing to remember is that the bond market has already priced in aggressive tightening and most expect the Fed to get its rate target to at least 3%. This would be above the peak before the pandemic; however, I do not believe the Fed has an appetite to push rates back to where they were before the 2008-09 financial crisis (the peak then was 5.25%).
If the US business and consumer spending growth slows into the second half, inflation will likely ebb, and this could prompt the Fed to pull back from its aggressive tightening pace. In terms of strategy, I believe it’s time to start adding lower risk government bonds back into the portfolio. It’s not that yields can’t keep rising, but we have probably seen the worst in terms of rate of increase in yields for this cycle.