The Fed must hike its rates

Comments by Franck Dixmier , Global CIO Fixed Income at Allianz Global Investors, ahead of the FOMC meeting on 21-22 March       

• We expect a 25bps hike at the next Federal Open Market Committee meeting as the US Federal Reserve won’t be satisfied with still high core inflation.
• The regional banks crisis is creating a lot of uncertainty about the magnitude of future rate hikes.
• Investors' expectations of rate cuts are a source of fragility for fixed income markets, and any further correction would generate volatility.

In the space of two days last week, tensions in the US banking system caused a major adjustment in US yield curves, triggering a drastic revision in the Federal Reserve's (Fed) rate hike expectations. In February, investors seemed to capitulate by adding more than 100 basis points (bps) on the Fed's terminal rate between the beginning and the end of the month. The banking system stress has reduced expectations to almost zero, and investors are now anticipating year-end rate cuts. This unusual event has made Fed chair Jerome Powell's speech to Congress in early March, in which he spoke of the need to push rate hikes higher than previously expected[1], completely obsolete.  

However, we believe that the Fed should continue to tighten its monetary policy. It cannot be content with the level of core inflation, with the Core CPI[2] at 5.5% year-on-year in February, against the backdrop of a resilient US economy and still high demand. We therefore expect a 25bps hike at the next Federal Open Market Committee (FOMC) meeting.

The dilemma, if there is one, would be to decide between the objective of price stability and that of financial stability. The European Central Bank demonstrated on 16 March that it has no qualms about this[3], and we believe that the Fed should follow suit. The Fed, and the authorities, have specific tools to deal with a possible liquidity crisis, especially since the crisis is currently limited to regional banks.

But the situation reinforces uncertainties about the amplitude of rate hikes to come. Those hikes will depend on the severity of the crisis in regional banks and the ability of the authorities to contain any contagion. The often-irrational nature of banking crises (market and depositor psychology) suggests that it is still too early to claim victory. A continued crisis could lead to a tightening of financial conditions and cause the Fed to pause. A quick resolution would lead the Fed to continue on its path of raising interest rates. But regardless of the terminal rate level, we believe the Fed will remain on a plateau.

Investors' expectations of rate cuts (-90bps between June and December 2023) are a source of fragility for the US fixed income markets. These aggressive expectations are a source of volatility and could put the middle part of yield curves under pressure.

[1] Source: Fed's Powell sets the table for higher and possibly faster rate hikes | Reuters, 7 March, 2023

[2] US Labor Department

[3] Source: ECB cuts through bank turmoil to keep rate hike pledge | Reuters, 20 March, 2023

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