Top US banks expect four Fed hikes and quantitative tightening in 2022
17:52, 10 January 2022
Goldman Sachs and the Bank of America (BofA) have raised their forecasts on US monetary tightening, stating that they expect the Federal Reserve to increase interest rates four times in 2022 and to begin decreasing its balance sheet as early as the third quarter this year.
The two top US banks justified their above-consensus calls by citing tight labour market factors, with the unemployment rate already reflecting full employment, rising wage pressures and sticky-high consumer prices.
The Federal Open Market Committee (FOMC) minutes released last week confirmed the Fed's hawkish shift, signalling a “faster” and a “sooner” pace of rate hikes and warranting the start of its balance sheet run-off “relatively soon” after hikes begin.
US money markets are now pricing in – with a 76% likelihood – a first hike as early as March, and slightly less than 90 basis points of hikes for the year, according to the CME Group's FedWatch Tool.
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Goldman and BoA expect the Fed to hike more than market pricing this year
Market pricing of cumulative rate hikes in 2022 vs Goldman & BofA expectations – Credit: Capital.comTighter job market: wage pressures kick-in
Although last Friday's non-farm payrolls fell short of market expectations at 200,000 in December against 400,000 projected – mostly owing to seasonal considerations – labour market conditions have already exceeded maximum employment, according to a recent Bank of America note.
Private sector employment increased by 807,000 jobs in December, much higher than expectations, while the unemployment rate decreased by 0.3 percentage points to 3.9%, below the FOMC's median long-run projection of 4%. Wage growth was also substantial and broad-based, growing by 0.6% month-on-month (m/m) or 4.7% year on year (y/y), which is much higher than the low 3% y/y average rate seen before the pandemic.
Companies are bidding up pay to attract and keep employees to fill historically high job postings, which is a strong indication that the labour market is tight, Bank of America said.
Unemployment rate and hourly earnings growth (m/m %chg) – Credit: KoyfinAnalysts at Bank of America believe that current labour market circumstances warrant the Fed starting its rate rise cycle as early as March and continuing with quarterly hikes afterwards, totalling four increases to take the Fed funds rate to a range between 1-1.25% by the end of 2022. If inflation stays robust, BofA sees a risk that the Fed may raise rates three times by July.
BofA anticipates the Fed will begin shrinking its balance sheet after the Federal Funds rate reaches 0.75-1%, which may occur in September according to its baseline projections.
Bond sell-off: 10-year Treasury hits 1.8%, real yields surge
US 10-year weekly change vs US 10yr real yields – Credit: KoyfinBond yields spiked last week following the release of the FOMC December minutes, as investors repriced fixed-income assets in the face of sustained inflation and expectations of higher interest rates.
The yield on the 10-year Treasury note increased by 26 basis points last week to hit 1.8%, the largest weekly increase since June 2020.
The 10-year real yield, defined as the difference in yields between the US Treasury note and the breakeven rate, also increased significantly to levels unseen since April 2021.
As we highlighted here, rising real rates reflect the Fed's hawkish shifts and have significant consequences for a broad range of asset classes.
Fed’s quantitative tightening: what does it mean for the market?
Fed's balance sheet as % of US GDP – Credit: TradingviewThe market was taken aback last week as FOMC minutes showed that board members contemplated starting to shrink the Fed's balance sheet (quantitative tightening) shortly after the first rate hike in order to rein in rising inflation.
Quantitative tightening (QT) is the polar opposite of quantitative easing (QE) and it involves the Federal Reserve allowing a part of its Treasury holdings to expire without being rolled over, therefore reducing the size of its asset holdings and the amount of liquidity flowing into the financial system.
The last time the Fed started a QT programme in 2015, it did so two years after the first rate rise, and its balance sheet shrank by around 10% relative to US gross domestic product (GDP) over the next four years. The Federal Reserve's balance sheet now exceeds $8.6tn, or 42% of GDP – the highest level since the Second World War.
"As a rule of thumb, each $50 billion in balance sheet reduction translates to an approximately 25 basis point increase in interest rates," Morgan Stanley Investment Global fixed income chief investment officer Michael Kushma told on Bloomberg TV.
The run-off of the Fed's balance sheet may be harmful to stocks that are highly sensitive to financial conditions and have already priced in strong growth since the risk of less market liquidity and higher interest rates diminishes the value of future cash flows.
QT contributes to the upward pressure on yields in the Treasury market by limiting buyers' firepower to purchase government securities in the secondary market.
Last but not least, QT may bolster the USD's attractiveness by widening policy divergences between the Fed and other central banks, particularly those that issue low-yielding currencies (such as the euro or the Japanese yen).
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