Will the Fed overtighten? Markets weigh the risks as FOMC hikes US rates by 0.75

Daniel Casali, Chief Investment Strategist at wealth manager Evelyn Partners, says that going into this meeting, market expectations of a hawkish Fed had increased:

‘This followed a broadening in inflation to the service sector that appears to be supported by strong wage growth from the August CPI report. The FOMC did not disappoint the market with its hawkish, “outsized” 75bps rise in interest rates for the third consecutive month. The FOMC is set to continue to tighten until it sees evidence of inflation slowing towards its 2% target.

‘The risks for financial markets are threefold. First, there remains uncertainty over when the Fed ends this rate hiking cycle. Second, the pace of the increase creates further risk for markets. Third, the economic consequences – which are experienced with a 12 to 18-month lag - will depend on the level and pace of hikes.

‘With respect to the first two points, there is some guidance from the FOMC’s latest interest rate projections, which are released at the end of every calendar quarter meeting. The FOMC median Fed Funds interest rate forecasts (the so-called “DOTS”) of committee members rose to 4.4% (3.4% in June) for end-2022, 4.6% (3.8% in June) for end-2023 and 3.9% (3.4% in June) for end-2024. These forecasts indicate that US rates are set to rise further from here before falling in 2024.

‘On the third point, the market has concerns that the Fed will overtighten and drive the US economy into recession. The latest Atlanta Fed “now cast” model estimates third quarter annualised real GDP to be just 0.3%, which follows two quarterly contractions.

‘Essentially, the Fed seems to be trying to drive down employment (and wage growth) through demand destruction but is complicated by labour supply shortages dating back to the pandemic that are raising costs for some firms. Nevertheless, one positive for the Fed is that wage expectations are starting to decline.

‘After peaking last December, the August National Federation of Independent Businesses (the small business survey) showed that those firms planning to raise compensation has steadily declined. Given its close correlation with wage rates and its value as a lead indicator, the Fed may not have to tighten as aggressively in the future, and it could sooth market concerns somewhat.

‘In summary, there are probably more upside risks for additional Fed rate hikes than downside risks. Looking forward, weaker growth poses downside risk to company earnings. We therefore favour the more defensive areas of the equity market, such as healthcare and consumer staples, over those which are more sensitive to economic growth (e.g. consumer discretionary). We also like commodity-related stocks (e.g. in the oil and gas sector), which are supported by elevated free cash flows from capital expenditure discipline.’