How the Fed is heading for a limit landing

The core PCE, which is the primary concern of the Fed’s policy, will maintain a high range in 22-23 years, far exceeding the 2% PCE target level. According to our neutral forecast, the core PCE in 22 years may be roughly at a high level of 4.8% year-on-year, and it may still be above 3% in 23 years; under the unfavorable scenario of steepening of the Phillips curve, the decline will be slower. That means continued sharp rate hikes.

The Fed may need to continuously raise interest rates to cause significant adjustments in the U.S. stock market and real estate market to bring U.S. inflation back to the target range. In the current policy direction of controlling inflation, if the Fed’s forecast data does not reflect a clear change in views on economic growth and the job market, it may allow the US stock market to undergo a drastic adjustment.

Rising policy risk around the Fed that a rate hike could lead to a hard landing of the recession is essentially a question of whether rate hikes need to exceed the natural rate. Historically, the period when the Fed raised interest rates above the natural rate was generally accompanied by a deeper and longer output gap turning negative.

We expect core PCE to remain high in 22-23. The Fed will continue to tighten, but not to rein in inflation at the cost of a negative output gap and recession. The Fed’s current forecast for the nominal natural rate is around 2.4%-2.5%, but this means that its assessment of the real natural rate is still a significantly negative output gap, roughly equivalent to the level of Q1-Q2 in 2020; For real-time growth trends, taking into account our forecast for core PCE, the nominal natural rate may have reached 3%.

Based on this, if the Fed raises interest rates to 2.8% in 2023 on its current path, monetary policy itself will not cause a recession.

Impact on the financial market: In terms of U.S. bonds, the long-term downward trend of the 10-year U.S. bond yield since Q3 in 1981 may reverse with the nominal natural interest rate, while the upward trend requires that each round of cyclical fluctuations has the characteristics of bulls and bears; The turning point of the cycle generally occurs when the rate hike exceeds the natural rate.

In terms of U.S. stocks, if the difference between the Fed’s policy rate and the nominal natural interest rate is used as an observation indicator, it can be seen that the relationship between this indicator and U.S. stocks has changed since the 1990s. Before the 1990s, the S&P 500’s gains and this indicator showed a clear inverse relationship. But after the 1990s, the relationship between the indicator and the S&P 500 was no longer clear.

But overall, as a full reflection of the expectations of economic fundamentals, U.S. stocks still showed an acceleration in the early stage of the rate hike with strong growth, and slowed down after the rate hike started; and after the recent two rate hikes exceeded the natural rate, U.S. stocks crashed in 2000 and 2007.

Historical experience shows that the tightening of the Fed and the strengthening of the dollar often lead to a decline in growth and tightening of financial conditions in emerging economies; however, in this round of the Fed rate hike cycle, the situation in emerging economies will diverge, and commodity exporters such as energy Fundamentals are supported, for example, some Gulf countries may still have investment opportunities in their dollar bonds.

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