Drew Angerer
By Olumide Owolabi
We expect rangebound US rates on high inflation & growth slowdown.
An assessment of the rates market at this year’s halfway mark reveals how much has changed, despite the key driver (inflation) remaining the same and as uncertain as it was at the start of the year.
Coming into 2022, we anticipated the current elevated inflation dynamic, which has given the Federal Reserve good reason to turn and remain aggressively hawkish. However, growing signs of weaker growth and a higher recession probability continue to strengthen the tail risk of a dovish tilt in the medium term.
All things considered, and as we discuss in our recently released Fixed Income Investment Outlook, our base view is that the Fed will remain aggressive in adjusting policy rates in the near term as inflation prints continue to the upside. We expect the fed funds rate to shift up to around 3.25%–3.75% temporarily in the medium term before normalizing towards the long-run estimates of 2.25%–2.50% if and when inflation starts showing signs of trending lower. We also think the Fed is likely to be more reactive on higher inflation data points (actual data and expectations), but less sensitive to slowing growth in the near term; however, that balance could change later in the second half of the year if growth deteriorates substantially.
The key risks to our outlook would be a scenario where an entrenchment of elevated inflation expectations pushes the fed funds rate path to be steeper, with a higher peak rate of around 4.50%, or a sudden collapse in demand or recession-level labor weakness that forces a rethink in policy adjustments, capping the fed funds rate at a neutral range of 2.25%–2.50%.
With this sort of tail-risk symmetry, we expect the trajectory of U.S. rates to be highly contingent on the path of inflation and inflation expectations. Using the U.S. 10-year Treasury rate as a proxy, we expect levels in a range of 3.00%–3.50% (with a tail risk of hitting 4.00% on elevated inflation expectations) over the next 12 months.
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