Capital Ideas^TM

Capital Group portfolio managers consider the latest interest rate rise from the US Federal Reserve and what we can surmise from the slower pace of hiking.

The US Federal Reserve has slowed the pace of its interest rate hikes but does not appear ready to declare victory over inflation. After four consecutive increases of 75 basis points (bps), the Fed boosted the federal funds rate in December by 50 bps to a range of 4.25% to 4.5%.

The latest hike came after the November consumer price index (CPI) report showed a downward trend in core inflation¹. Cooling inflation could give the Fed room to further pare back the number of future hikes but Chair Jerome Powell’s comments and the Fed‘s latest rate forecast indicate the central bank is not yet planning to back down.

“It will take substantially more evidence to give [us] confidence that inflation is on a sustained downward path,” Powell said, noting that Fed officials still do not feel policy is restrictive enough, even after this latest hike. He pointed to the tight labour market as an ongoing issue, highlighting that “wages are running well above what is consistent with 2% inflation.”

The December dot-plot chart, which shows individual Fed governors’ median rate expectations, points to a peak of 5.1% for the federal funds rate, up from 4.6% in September. The forecasts for 2024 and 2025 also rose, growing by 0.2% each since September to reach 4.1% and 3.1%, respectively.

Here are the latest views from fixed income portfolio managers Tim Ng and Tom Hollenberg on the US economy and their expectations for Fed policy.

1. After a year of aggressive interest rate increases, we expect more hikes, but overall we think the next several months will bring a less dramatic policy environment. Slowing inflation suggests 75 bps increases are unlikely to continue, and Powell signalled a preference to downshift to 25 bps in February.

2. Inflation has probably reached its apex, but we think it will remain elevated for some time. The economy is slowing, and recession risks are high, but a resilient service sector may continue buoying growth and inflation. We expect core PCE (personal consumption expenditures) inflation to remain meaningfully above the Fed’s target of 2% for a while, eventually settling around 3% to 4% by the end of next year.

3. While the market is pricing in rate cuts in late 2023, we believe the persistence of inflation makes that scenario less likely, unless there is a shock to the labour market. Recent US employment data indicates wages are still growing, which means the Fed likely has more work to do. Jobless claims are also declining, even with a rash of layoffs in the tech sector.

4. We favour an underweight position to duration (how sensitive bonds are to moves in interest rates) given persistent inflation, a still aggressive Fed, and our view that the market’s expectation for cuts is too extreme.

5. Due to the negative slope of the yield curve (where long-term yields are less than short term), we favour underweights in longer end (10-year to 30-year) US Treasuries. Given current valuations, we view a yield curve steepener (which benefits as long term rates move higher than short term) as an attractive longer term portfolio position in advance of an eventual pivot on rate policy from the Fed.