The U.S. Federal Reserve has raised interest rates by 25 basis points. But it does so at a time of heightened uncertainty and risk. Anthony Okolie speaks with Scott Colbourne, Managing Director, Active Fixed Income, TD Asset Management, about the unique challenges facing policymakers.
SCOTT COLBOURNE: Tony, the Fed was definitely hawkish. As you said, it was expected they were going to raise rates 25 basis points today. Chair Powell gave us that guidance back in early March. There's lots of surprises here. Certainly, there was one dissent. Governor Bullard wanted 50 basis points today, so that was a bit of a surprise, in terms of the members, all voting 16 members today.
And then certainly something we'll talk a little bit more about is all the forecasts. And they definitely laid out a path of substantially more aggressive rate hikes going forward than the market had expected.
ANTHONY OKOLIE: Yeah, let's talk a little bit about the Fed's dot plots because, as you mentioned, they're a bit more aggressive. They're now forecasting six more rate hikes this year and possibly three or four more rate hikes in 2023, which, as you said, are more aggressive than some had anticipated. What's been the reaction by markets so far?
SCOTT COLBOURNE: Yeah, the markets have definitely taken note. It's a hawkish reaction. As you said, seven hikes in total this year. So if you go back to the December meeting, it was three, three, and two over the next '22 '23, and '24. And we've moved from seven to three to nothing. And so you sort of see short term rates peak out in 2023 and 24 at 2.75
That's sort of the median dot plot. Certainly there's a range of people expecting more. So it's definitely telling the market, and the market's taken the cue, that the Fed is upping the ante. It's having to move. The current policy stance doesn't make any sense given the level of inflation, growth, and unemployment.
And so we've seen a flattening in the yield curve. So the front end, two years, five years, in particular, have gone up anywhere 10, 15 basis points in the immediate aftermath of the announcement. So we've seen a flattening of that yield curve. Long end rates have gone up a little, bit but less so. So that is expected. We expect the yield curve to continue to flatten going forward.
I would note that one a little bit of a surprise for me was the fact that they lowered the terminal rate. So last meeting in December, the markets were looking at 2 1/2 as the, long-term median Fed funds rate. And it's at 2.4. So what to really note is the difference between 2022 and 2023, and '24, excuse me, and the terminal rate.
So you've got a more restrictive policy than the long-term expected policy rate. So another signal out of the Fed that they are definitely wanting to put the brakes on inflation and slow things down here.
ANTHONY OKOLIE: And the Fed seems to be walking a very tight balancing act right now because there's growing concern that the Fed's attempt to tackle inflation could also end up hurting growth, economic growth. And we're starting to hear more and more people talk about a possible recession. How big a risk is that?
SCOTT COLBOURNE: Yeah, it's a genuine risk. Certainly, the curve is flattening, and that's always a signal that most of us as investors pay attention to. And if we get to 2.75 and we get 10 year and 30 year rates up in those range, that's definitely telling you that the economy and the yield curve is flat.
So I think the tension for the Fed is between what we would go back-- and, using the language of last year, the tension between the transitory element of the supply shock to inflation and the expected unwind of that over the course of this year and into next year, versus needing to put a bit of a brake on the economy with more tighter financial conditions, or tighter monetary policy just to slow the economy and slow aggregate demand.
On balance, I think the Fed leans towards the transitory element, but is certainly shifting policy and will adjust and has made it clear that 50 basis points-- every meeting is live. 50 basis points can be at any meeting as well. So it's that real tension in the market. There's no clear answer, but certainly that is a great question and certainly the one the markets are grappling with here.
ANTHONY OKOLIE: Another notable development was that the Fed decided not to start unwinding its $9 trillion balance sheet at this meeting. What was behind that decision to hold off?
SCOTT COLBOURNE: Well, I think, if you will, they're going to keep a few cards in the back pocket. They definitely tighten monetary policy here. They've been more aggressive, surprise the market. They've told us that-- in the past, they've said they would prefer to have the balance sheet unwind as a bit of an autopilot, or a non-issue.
But certainly, they can change the trajectory of the balance sheet unwind. And that could be another element of a tighter monetary policy stance. So we'll probably get more details next meeting, in May, a May hike and the details on QT. But for the moment, they've definitely told the market they're very aggressive here in terms of monetary policy stance.
ANTHONY OKOLIE: Now, I want to talk a little bit about some of the risks to their outlook. Certainly, there's inflation. There's the Russia-Ukraine conflict. What do you think are some other big risks right now to the Fed's path on interest rates?
SCOTT COLBOURNE: Yeah, the big picture is that we've got challenges like the Ukraine-Russia war. We've got a COVID shock in Asia and China. And we've got buffeting the financial markets and creating a lot of uncertainty. So obviously, there's uncertainty in forecasts and policymaking here. But I think, in general, we sort of broadly talk about it with a number of our colleagues in the other departments, like asset allocation equities, is that we're moving into a regime of inflationary surprises and shocks.
Unlike the ability of central banks to address shocks to the market when inflation was really under control, we got the notion of a Fed put, or the support for the capital markets. And in this case, inflation is a key policy variable for the Fed, and it's going the wrong way.
And so that Fed put and the Fed cushion is really not going to be there. So we're definitely creating a lot more uncertainty for financial markets and financial returns going forward.
ANTHONY OKOLIE: And I want to talk a little bit about the US dollar. We did see a little bit of a bounce after the announcement. Where do you see the greenback going over the next little while?
SCOTT COLBOURNE: I mean, I think this continues to underpin a bit of support for the US dollar, particularly against central banks that are not responding in the same fashion as the Fed. So obviously, the Bank of Japan and, to a lesser degree, the European Central Bank as well.
So pressure, again, will probably emerge on Europe on the euro in the end, what we call the funding curriences, against the dollar. That being said, the broad commodity support, the supply shock on commodities, is giving a lift in terms of trade adjustment to a number of emerging markets as well as Canada, Australia, Norway, for example.
So there'll be a bit of a cross current in, say, $1 CAD, where we're supported by a central bank that's going to be responding to higher inflation and the commodity positive tailwind, but against the fact that the Fed is being more aggressive. So continued range trade in the US dollar, Canadian dollar relationship, with a slight bias to a stronger level in the CAD.
ANTHONY OKOLIE: Scott, thank you very much for joining us.
SCOTT COLBOURNE: My pleasure. Always a pleasure to be with you. Thanks.