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IN line with ours and market expectations, the US Federal Reserve (Fed) raised the policy rate by another 75 basis points (bps) although some were looking at 100 bps. With September’s rate hike, the Fed’s policy rate is now at 3% to 3.25%.

More rate hikes are expected over the next two meetings in November and December.

Inflation is envisaged to remain sticky. With that, the Fed’s door is left wide open for a fourth consecutive 75 bps hike in November and 50 bps in December 2022.

For December, we certainly cannot dismiss the possibility of a fifth 75 bps hike.

Hence our baseline suggests that the Fed rates should settle at 4.25% to 4.50% while the upside is at 4.50% to 4.75% by end 2022.

Looking at the real rates, they have come under pressure as inflation expectations managed to ease post the rate hike.

Rate cuts in 2H23

Looking ahead, the geopolitical backdrop, the China slowdown story, the potential for energy rationing in Europe, the strong dollar, and fragile-looking domestic equity and housing markets point to clear sharp slowdown or mild recession risks.

A more aggressive Fed rate hike and tighter monetary conditions will only intensify the threat.

Meanwhile, there are encouraging signs on both market and household inflation expectations, and also corporate price plans which suggest inflation may not be as embedded as some in the market fear.

Long-term price expectations have returned to what we might term “normal”. This suggests fears of a 1970s wage-price spiral is being misplaced. It also means there are growing confidence that the Fed will indeed get inflation down.

With the risks to growth and the potential for lower inflation, we now expect the Fed to cut rates throughout the 2H23. We foresee four rate cuts by a total of 100 bps. Fed’s decision will be data dependent. Our baseline Fed policy rate outlook for 2023 would reach 3% to 3.25%.

Market rates are now under pressure, chasing for a higher terminal rate.

The latest move by Fed resulted in a significant impact. And expectations are that it can come closer to 5% in 2023. It is supported from the messaging of the Fed who intends to maintain a tightening trajectory beyond the end of 2022 and into 2023.

Meanwhile, the 10-year yield now needs to consider a path towards 4% in the coming couple of months. Past records showed the 10-year hardly trades more than 50 bps through the funds rate before the Fed has peaked. A 50 bps is an exception. A more normal discount would be 25 bps ahead of a confirmed peak from the Fed.

Looking at the real rates, they have come under pressure as inflation expectations managed to ease post the rate hike. It is certainly a positive news from ours and the Fed’s perspective. While higher real rates will help tighten financial conditions, the easing in inflation expectations tells us that the market ultimately expects the Fed to see inflation fall.

But we are yet to witness any narratives for inflation to fall.

The thing is, the case for big falls in inflation has yet to be proven. If we are right and the Fed does in fact peak by year-end, then that fall in market rates anticipated is back on track.

Still a dollar-play

The Fed’s has signalled to the foreign exchange (forex) markets that it would cut growth and raise unemployment forecasts while inflation will still be higher than previous forecasts and that the policy rate could be as high as 4.6% by the end of 2023. Logically, this undermines Fed “pivot” ideas.

This will see the forex market biased towards slow-down or mild recession. And such playbook will really favour the dollar over pro-cyclical currencies.

Hence, investors should not be in a hurry to quit the most liquid forex reserve currency – at a time of escalating war in Ukraine. And if we look at the 1980s Paul Volcker period, the Fed had to bring the US economy into recession to get inflation under control. The dollar soared during this period.

Further strength in the dollar will see trading partners respond as much as they can. The European Central Bank is “attentive” to euro/us dollar weakness but is never going to be able to match the 4%+ Fed policy rates coming on their way.

Unlike the US economy, the eurozone is in a negative output gap. And given the events in Ukraine, it is hard to rule out a further grind towards 0.95 over coming months.

More pressing is US dollar/yen which is again closing in on 145. Japanese authorities remain close to pulling the trigger on forex intervention. There will be a Bank of Japan (BOJ) meeting next in this week. No change is expected from the dovish BOJ – but a tweak to the Boj’s 10-year Japanese Government Bond target (0% to 0.25%) and intervention would certainly catch the market unawares. We believe the US dollar/ yen traded volatility is too cheap.

On the US dollar/ringgit, there is still weakening pressure on the local currency. The aggressive monetary tightening by the Fed and complemented with the ongoing external headwinds should now see the local currency trade close to 4.60 against the US dollar. On yearto-date (y-t-d) basis, the ringgit has already depreciated 9.5% going against the bullish dollar.

Before the meeting, the ringgit closed its position slightly stronger against the greenback, marking a slight relief after seventh consecutive days of weakening trend. It posted 0.12% higher compared with the previous day to 4.553. But after the Fed’s decision, the ringgit erased any gains made and sank 0.31% to close at 4.568.

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