There have been three important phases in the Fed’s rate cycle campaign since last year, in our view. The first was late last year / early this year when it downshifted the pace of rate hikes. This in turn started the debate of policy rates being closer to desired peak and the discovery process of what the terminal policy rate could be. As this issue started to get broadly settled, the debate started shifting from ‘how high’ to ‘how long’. Fed officials were weighing in on the ‘higher for longer’ side, a view that markets had to finally take note of when in the September FOMC median expectations of Fed funds rate as at end 2024 was hiked by 50 bps to 5.1%. This was a notable contributor to the aggressive move higher in long term US rates over September and October.
The December policy starts the third important phase. The FOMC statement, and Chair Powell’s press conference afterwards, constitutes a pivot in our view, for the following reasons:
1. The predisposition towards hiking further has been removed by tweaking the statement (addition of the word ‘any’ as qualifier to need for additional tightening). This, combined with dot plots showing no further hike projections from FOMC participants, effectively signals the end of the hiking cycle. Not just that, FOMC median projection for end 2024 has fallen back to 4.6%.
2. More importantly, however, in the press conference Powell actively entertained a discussion on possible rate cuts over 2024 including alluding to such discussions beginning within the FOMC participants as well. Further, in response to a question asked, he acknowledged the need to be aware of the risk on holding rates for too long. Importantly, Powell also clarified that waiting for the 2% target to be achieved before deciding on cutting risks overshooting to the downside.
A view going into the policy was that the Fed would use it to actively push against market expectations of significant cuts next year, that had sprung up basis softening data since October. In the event, the Chair ended up acknowledging the data softening in some sense, moving closer to market expectation. Of course, as is its nature, the market has moved on pricing almost 150 bps of rate cuts over 2024; almost double of what is implied by FOMC median dot plots.
While market aggression may well get frustrated yet again as it has been many times over this cycle, one has some sympathy for the view. By the Fed’s own dot plot, the median expectation is for GDP growth to de-accelerate to below trend next year and unemployment rate to rise 40 bps from its current level. A lot of economists and market participants believe that once the de-acceleration starts and unemployment rate starts rising, there is a clear risk that the process becomes self-iterative. In that case the damage may be of a higher order than what is currently being assessed by the Fed. The policy response may then need to be more aggressive than what FOMC members may currently be expecting. That said, and as has been seen over the past few months, expectations have a way of fluctuating wildly basis incoming data. So any assessment at a point in time only has that much volatility.
Takeaways
There are some clear takeaways for the purpose of monetary policy expectations that got profiled from the Fed meeting yesterday. While the context is different for India, the general applicability nevertheless stands:
1. Central banks don’t necessarily wait for inflation targets to be met before starting to ease policy rates. As an example, the Fed doesn’t expect its inflation target to be exactly met even by 2025 but nevertheless expects to cut policy rates by 180 bps by then. The underlying logic for why this is the case is sound: if policy rates are kept constant as inflation falls, the so-called real policy rates actually rises thereby incrementally tightening monetary policy. Thus it is important to calibrate nominal policy rates to falling inflation even if the latter is above target, if the extent of policy tightness is to be kept constant. This is especially true if the inflation fall is alongside a fall in GDP growth rate to below trend.
2. As is the case with markets, central banks also formulate expectations basis evolving data. Their reaction function may be more conservative, but they also change view basis incoming information, sometimes significantly. Thus the Fed has gone from not even thinking about thinking about rate cuts to actively starting that discussion, over a relatively short period of time. To be clear, this isn’t offered as criticism of the central bank. The point only is that one shouldn’t take concurrent commentary as a line in concrete, especially around the turn of cycles when data tends to move around more meaningfully.
The above two observations are made to counter a market view that since RBI has projected strong GDP growth for next year and inflation still runs above target, there won’t be room for rate cuts. We disagree and think it is likely that RBI will likely deliver 50 – 75 bps cuts over the next financial year, with a risk that it is deeper in case the West has a ‘hard landing’.
Strategy
We have been highlighting our bullish bond view basis three triggers: : 1> A likely global policy rate cycle peak 2> India’s benign current account dynamics arguing for stable long term rates 3> Probable greater internationalization of interest in Indian bonds with the proximate trigger being the index inclusion. Basis this we have been suggesting that it is time to elongate portfolio maturities, especially considering very short end allocations done over the past year or so given high rate volatility and attractive bank deposit rates. The Fed decision yesterday further strengthens the first of our three triggers, insofar that it explicitly calls out the peak in the global rate cycle.
We have been overweight 14 year government bonds in our actively managed dynamic and gilt funds. This continues but we have also added some exposure to 30 year government bonds in these products recently. This is consistent with the view and triggers described above.
Source: Bandhan MF Research
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