Fidelity forecasts 3 to 4 rate hikes by Fed this year

The new year has ushered in fresh tensions and volatility in global markets, largely due to the rapidly changing response to inflation by central banks. With inflationary pressures continuing to mount in 2021, central banks have tightened policy sharply. In just a few weeks, all major central banks have made policy adjustments to the outside world.

Inflation is no longer a fleeting phenomenon, but a definite risk that countries need to grapple with. Of all these changes, the ECB's shift in attitude is most pronounced. Compared with the Fed, Bank of England and other central banks, the ECB has in the past insisted on extremely loose monetary policy. However, the ECB's Governing Council is also feeling the pinch after inflation unexpectedly continued to rise. Even though no measures were announced at the January meeting, European Central Bank President Christine Lagarde did not refute market expectations for policy tightening.

At the same time, the Fed gave the market more details about the tightening cycle. A rate hike is imminent, and the asset purchase program is also expected to end in early March. In addition, the Bank of England raised interest rates by 25 basis points in January, but many people support a 50 basis point rate hike. The market quickly digested policy expectations and expects short-term yields to rise sharply, with higher yields and a flattening curve. Central banks are unlikely to take the initiative to fight back against these expectations in the short term, instead allowing markets to adjust and pave the way for policy tightening before taking the initiative until later in the year. Following a rebound in 2021, Fidelity expects economic growth to moderate in the second half of 2022, along with some easing in inflation, as temporary drivers of the economy fade and base effects come into play, according to the economic data at that time. will be extremely critical.

The market generally expects the Fed to raise interest rates six times this year, which is equivalent to raising interest rates once after each meeting in 2022. The pace of quantitative tightening has yet to be determined. Fidelity expects the balance reduction to begin earlier than in the previous cycle (roughly after one or two rate hikes), while the reduction will be larger at least initially. Assuming the same pace of quantitative tightening (QT) versus quantitative easing (QE) as before, both Treasury and mortgage-backed securities (MBS) are expected to contract at a rate of up to $90-100 billion per month, equivalent to the previous cycle's highest twice the value. However, the market's current expectations for the Fed's rate hikes and balance sheet reduction this year appear to be too high. The Fidelity Global Fixed Income team believes that the Fed's best strategy is to do multiple quick rate hikes, then stop raising rates and start QT, or do QT while slowly raising rates.

Fidelity's base forecast is for the Fed to raise rates three to four times this year, rather than the current consensus of six. Also, real interest rates will remain a barometer for the Fed and risk assets. Due to the high debt burden since the new crown epidemic, real interest rates will need to stay in negative territory for a long time, and the total debt is likely to remain at sustainable levels. The Fidelity Global Fixed Income team believes that maintaining negative real interest rates is the implied policy objective of all major central banks today.

In Europe, markets will mainly focus on the European Central Bank's meeting in March this year, when the European Central Bank will release its latest macroeconomic forecasts and more clarity on the details of its asset purchase program. The ECB is expected to run its net asset purchase program until the end of the year, which means the first rate hike could happen as early as early 2023, based on the sequence of policies. The European Central Bank is likely to speed up its tapering of bond purchases and end net asset purchases by the end of 2022, in order to meet the conditions for raising interest rates earlier if necessary. While the asset purchase program may end in June, Fidelity prefers to think the QE exit will be delayed until the third or fourth quarter. Like the Fed, the market generally expects the ECB to take a very aggressive path, expecting a 50bps rise in deposit rates over two years as a terminal rate, and a further decline in the yield curve. The 10-year yield still has room to rise further, but Fidelity sees that room at around 20 basis points. On the quantitative easing front, markets are expecting the ECB's asset purchase program to end earlier than expected as financial conditions are quite accommodative and economic performance is expected to rebound from a weak first quarter. As a result, pressure on interest margins in the European peripheral markets will persist.

Central banks are facing challenges and their policy measures have lagged market conditions. Now, as the risk of "policy mistakes" rises, they must catch up. Despite recent efforts, there will still be considerable resistance to the next policy adjustment by central banks. It is imperative for markets and investors to be well prepared for the volatility and uncertainty to come.