How high will hawkish Fed push interest rates in the next year?

Portfolio manager gives his take on chair Powell's next move

How high will hawkish Fed push interest rates in the next year?

When the U.S. Federal (Fed) Reserve Chair, Jerome Powell, addresses the annual global central banking conference in Jackson Hole, Wyoming, on Friday about its anticipated moves this fall, TwentyFour Asset Management expects the U.S. Federal Reserve to remain hawkish.

“We don’t see any surprises. We expect Powell to reiterate his fight on inflation and say that is their number one focus,” David Norris, a New York City-based portfolio manager for TwentyFour Asset Management, a boutique of Vontobel Asset Management, told Wealth Professional.

“I think they’re going to dissuade the market from any notion that the Fed has made a dovish pivot, but is rather focusing on the fight to bring inflation under control, even if that could run the risk of pushing the U.S. economy into a recession. So, I don’t think that narrative will change.”

Powell could use his highly anticipated speech to signal how high the U.S. borrowing costs could go and how long they would need to stay there to reduce inflation.

Norris said while the recent U.S. consumer price index (CPI) numbers were favourable, with some prices – such as energy, air fares, and used car sales – decreasing, the Fed pays more attention to the core personal consumption expenditure (PCE) price index, which will also be released on Friday.

There will also be another CPI rate released before the next Fed meeting, but Norris said although the Fed’s minutes show Powell has suggested that the bigger increases will stop at some point, Norris expected that the Fed rate could be 3.75% by mid-2023.

“I think the market has priced in more of an expectation of a hawkish statement from Powell,” he said, noting that the market is pricing in up to 3.75% by the end of 2022. “So, I think we could see a less hawkish speech. We could see a rally from where we are now.”

Norris said that while there are signs that U.S. inflation may have peaked, there is still an upward inflation trajectory overseas. Europe, which has energy concerns because of the impact of Russia’s war on the Ukraine, hasn’t reached its peak inflation yet. Inflation is accelerating at an even faster rate in the United Kingdom, where he said the Bank of England has indicated it could reach 13%.

“We’ve seen a rally in credit spreads across the UK and European markets, to the tune of over 100 basis points,” he said. “Now, we’re seeing some profit-taking, a little correction, and credit spreads a little wider than we’ve seen over the last while.”

While there has been speculation about whether the Fed will raise interest rates another 50 or 75 basis points after its next meeting in September, Norris said TwentyFour is expecting 50 basis points.  So, it’s remaining with shorter duration asset allocations in its portfolio and retaining sufficient liquidity to be able to invest when opportunities arise from market pullbacks.

“Given the spreads and yields that we saw toward the end of June, there’s really only been a few periods over the last decade where we’ve seen the type of levels that we had available to us in that period of time,” said Norris, adding they could now be closer to end of cycle positioning. “So, we may be a little bit more defensive in nature.”

TwentyFour particularly likes the Canadian energy sector, particularly midstream companies with stable contracts and predictable cash flows. It also likes European financials, especially in this rising rate environment, and the strong capital bases of European banks.