Fed: A looming interest rate hike?

The Federal Reserve has begun to publicly "speak down" on interest rate cuts, and the S&P 500 continues to hit new highs. Should we worry about the "surprise" of raising interest rates? The minutes of the January Federal Reserve interest rate meeting released early Thursday morning made the market "sweat" to some extent - "Most participants noted the risks of moving too quickly to ease the Stance of policy", this behavior of "denigrating" the interest rate cut theory reveals at least two signals: the interest rate cut will not start too soon, and the last interest rate increase may not be "final". Somewhat tacitly, the performance of the market since February has also begun to gradually downplay the narrative of a soft landing and the Federal Reserve's imminent pivot - U.S. bond yields have risen sharply, while the stock market has performed equally well, with the S&P Index continuing to "conquer territory" above 5,000. ". Behind the more optimistic expectations, the "phantom" of interest rate hikes seems to be looming.

So, how to evaluate the hidden worries of the Federal Reserve raising interest rates? We believe that at least three conditions (employment, inflation and growth) may have to be met, and the threshold for these three conditions currently seems to be high. There is indeed uncertainty about the timing and space of interest rate cuts this year, but the probability of restarting interest rate hikes currently seems low.

How likely is it that the Fed will return to raising interest rates? We believe we can gain some insights from the Fed’s unexpected rate hike in 2023. The dot plot of the Federal Reserve's interest rate meeting in December 2022 suggests that interest rates will be raised three times in 2023. However, due to concerns about recession, the market's policy expectations are more "radical" - it will stop raising interest rates in June and start cutting interest rates in July. The final result is that the Federal Reserve will raise interest rates four times in 2023, with the last increase in July and no interest rate cuts throughout the year.

Looking back at the U.S. economic and market environment in the first half of 2023, against the market's recession expectations and the bankruptcy of Silicon Valley Bank, what is the "confidence" for the Federal Reserve to raise interest rates beyond expectations? We believe it may come from three important economic conditions:

First, the monthly new non-agricultural employment continues to remain stable at 200,000 or even more than 300,000 people, and even exceeds 500,000 in some months, indicating high demand and strong resilience in the job market;

Second, the core inflation growth rate has not shown a significant downward trend and continues to be above 0.3%. Core inflation faces the risk of accelerating at any time;

Third, the U.S. real GDP annualized rate is around 2.5%, and even reached 2.6% and 2.7% in the third and fourth quarters of 2022. The economic performance is particularly strong.

Therefore, from the above three aspects, the threshold for raising interest rates again this year is not low. Although January's employment and inflation data exceeded expectations, there is some noise behind it due to seasonal, weather and statistical changes. We are confident that the U.S. economy will continue to maintain strong performance in terms of employment, growth and inflation in the next one to two quarters. "Strong" has doubts:

Short-term data disturbances, the job market is still gradually cooling. For the job market, the sustainability of the unexpected new non-agricultural data in January is questionable. On the one hand, the non-agricultural data at the beginning of the year is usually affected by weather and data caliber adjustments, and there is a lot of noise; on the other hand, many labor force data Market indicators still point to continued cooling of demand, with the number of job vacancies showing a continuous downward trend and the recruitment rate already lower than the pre-epidemic level. In addition, the supply gap is gradually closing, the labor force participation rate is steadily recovering, and the labor market supply and demand are moving toward balance. Since 2021, the center of new non-agricultural employment every year has gradually declined, falling to 255,000 in 2023. Before the epidemic, this center was below 200,000 from 2016 to 2019.

Although the economy is still resilient, the lagging impact of high interest rates and slowing fiscal pulses will drag down subsequent economic performance. Although the U.S. economy once again delivered outstanding results in the fourth quarter of last year, it showed the resilience of the economy. However, historically speaking, due to the influence of seasonality and climate, the U.S. economy usually declines in the first quarter, and as the excess savings of U.S. residents decline, the supporting role of consumption in the economy will be significantly weakened. The latest GDPnow shows that in the first quarter The contribution of consumption to real GDP has been reduced from the original forecast of 2.4% to 1.8%, and the decline in consumption is still ongoing.

What may be more important is that the active fiscal policy that effectively supported the economy in the third and fourth quarters of last year will become an important drag this year, and the lagging impact of higher interest rates will also be reflected this year.

But among the three factors, inflation may be the most uncertain. As of December 2023, the U.S. core PCE has dropped below 3% year-on-year. According to our path interpretation, if the core PCE is to rebound to more than 3% year-on-year before the interest rate meeting in March or May, triggering the Federal Reserve to consider raising interest rates, then Its monthly average month-on-month growth rate needs to be stable at 0.5% or 0.4% respectively, which is inevitably somewhat unrealistic. And even if inflation is likely to rebound faster than expected in the middle of the year, since the other two conditions are not yet mature, the impact may be more on the delay of interest rate cuts than on the restart of interest rate increases.

Risk warning: Global inflation has risen beyond expectations, the U.S. economy has entered a significant recession ahead of schedule, the Palestinian-Israeli conflict has spiraled out of control, the U.S. banking crisis has resurfaced and financial risks have been exposed, and the Federal Reserve has cut interest rates beyond expectations.