Fed Rate Hike Likely to Begin in March

The Federal Open Market Committee (FOMC) left the Fed Funds rates unchanged at 0-0.25%, but indicated that a rate hike beginning in March was extremely likely. The statement made no mention of “gradual” hikes thereafter, which is language that the Fed has used to signal quarterly rate hikes, and which was widely expected by investors. The ambiguity is potentially hawkish.

Despite some market concern that the Fed was going to fully taper its QE bond-buying program immediately, the FOMC also noted that full tapering would conclude in early March.

The Fed also released a separate document that provided some guidelines it would follow on the “quantitative tightening” (QT) process. Powell also said that the Fed has yet to decide how and when balance sheet will be reduced, and indicating that while no decision had been made on future rate hikes, the Fed was not ruling out a rate hike at every meeting (there are 8 Fed meetings per year).

Citi’s impression is that the combination of the statement and Powell’s press conference was very hawkish, but by declining to provide more guidance on timing and scope of QT, the Fed thinks that it has left itself some optionality in terms of when it may use this policy tool in addition to rate hikes.

Immediate market reaction in Treasury yields on Jan 26 was a sharp move higher for all maturities by 5-15 bps, primarily in the front end of the curve which is now fully pricing 4 rate hikes this year and a Fed funds rate in Dec 2024 of about 2.0%.

Per the FOMC’s statement and the subsequent market reaction, Citi analysts think that the Fed is likely to remain on track for at least four 25bps rate hikes in 2022, with the first rate hike in March and the market starting now to price in the possibility of a 50bp hike. Given the lack of details of QT, it is more likely that the Fed may wait and see how the market digests a potentially faster rate hike path before fully determining an appropriate balance sheet reduction strategy, but once it does, Citi analysts expect an average of at least US$50bn a month. However, QT may start by this summer if inflation levels are not reducing quickly.

Citi’s base case is that we do not expect Treasury yields to rise much over the course of the year (our current year-end estimate for the 10y remains at 2.15%, about 35bps higher than currently). Citi’s base case remains headline CPI declining from 7% currently to 3% by year-end, which if realized, is likely to give the Fed time to take a more gradual tightening path.