Fed likely set for a 75bp hike and more balance sheet reduction

It’s hard not to fixate on comments from the Fed’s Bullard suggesting that a 75bp rate hike would not be off the table in May. For good reasons, the Federal Reserve is still trying to gain control of the inflation narrative on Wall Street but far more importantly on Main Street. It is yet to succeed, but likely will prevail by front loading tightening as Jerome Powell suggested on Thursday when he confirmed 50bp is in the cards for the May meeting.

The Fed uses two tools to impress Main Street:

1. An expected rapid set of interest rate increases that are yet to have an impact on surging real estate prices but are affecting first-time and low-income buyers. Other buyers are flushed with equity gains post Lehman crisis while the housing supply has not been able to keep up with.
2. The Fed’s proposed balance sheet reduction is impressive. However, a quick look at the resilience of Bitcoin and its QE infinity mantra reveals that it does not convince Tech savvy households. In addition, Megacap Tech has somewhat deflated but remains very expensive, e.g. Tesla. Netflix, for example, is only dropping as a result of lower subscription numbers not due to fear of higher real interest rates.

To gain back control of the narrative, the Fed may well surprise with a 75bp rate hike on May the 4th and a faster run down of its balance sheet, particularly in its long-dated bonds book. Larger rate hikes initially don’t change the end point of the rate hiking cycle, but it does leave the Fed with a conundrum: Can the Fed surprise the market without sending equities into a vicious negative feedback loop and the US economy into a rapid economic slowdown? Most likely yes, and it should be helped by inflation having peaked on the back of more subdued energy prices and some improvements in the supply chain.

The danger of getting it wrong is significant but small. The US equity market is expensive and debt has built up post 2010 (see Graph below). While leverage ratios are sound as a whole, a poorly managed Fed operation would have a considerable negative impact on US credit and equity.

Non-financial debt has been on a sharp increase since 2011, but leverage dropped as equities surged.