• Heightened uncertainty has weighed on financial markets in 2022, and the escalating conflict in Ukraine presents new complexities to the domestic and global economic outlooks
  • The Fed is set to raise the federal funds rate at the March 16 FOMC meeting, and Fed Chair Powell said the economic impact of the Russian invasion of Ukraine remains “highly uncertain”
  • The U.S. economy remains on strong footing as we approach the end of Q1, but elevated financial market volatility could persist in the near-term due to uncertainty related to monetary policy and geopolitical events

Financial markets do not like uncertainty in its many forms. Uncertainty regarding fiscal policy, monetary policy, geopolitical tensions, and public health crises, just to name a few, make financial asset modeling and valuation even more challenging. Uncertainty is risk, and when elevated, healthy two-way market flows can (and likely will) dissipate. This is an appropriate characterization of what we have experienced so far in 2022, and as we discussed in last month’s commentary, volatility could remain elevated until we get a clearer picture of the inflation outlook and the Fed’s subsequent response via interest rate and balance sheet policy. However, the worsening situation in Ukraine and questions surrounding Vladimir Putin’s ultimate military intentions have inflamed what were already-volatile markets.

The Fed has a difficult job ahead of them, and the situation in Ukraine/Europe only adds complexities. January inflation readings set new multi-decade highs, and prior to Russia’s invasion, markets were pricing for an aggressive response from the FOMC with regard to rate hikes and balance sheet reduction. As a result, bond yields surged higher, particularly in the front-end and belly of the yield curve, and fixed income spreads widened sharply. Prior to Russia’s invasion of Ukraine, the bond market was pricing in 150 basis points (bps) of rate hikes in 2022, including a high probability of a 50 basis point rate hike for the initial liftoff at the March 16 FOMC meeting. However, as the situation deteriorated, a global flight-to-quality trade sent short and intermediate Treasury yields 20-27 bps lower, and the market is now pricing for one less rate hike in 2022.

On Wednesday, all attention shifted to Fed Chair Powell and his testimony before the House Financial Services Committee. This was already going to be a closely watched event given much uncertainty regarding the Fed’s plans for rate hikes and balance sheet reduction, but the geopolitical crisis made for an even more challenging task for Powell. In his prepared statement, Powell made it clear that the Fed was still on schedule for the first rate hike on March 16 with the labor market “extremely tight” and inflation well above the 2% target. Regarding the impact of the war in Europe, he said the near-term impact on the U.S. economy remains “highly uncertain.” The statement didn’t provide any new information about balance sheet reduction, reiterating that it would only begin after rate hikes had started and that rate hikes remain the Fed’s primary monetary policy tool. He also added that any balance sheet runoff will “proceed in a predictable manner primarily though adjustments to reinvestments.” By interjecting the word “primarily,” Powell didn’t fully shut the door on asset sales, but he makes it fairly clear that sales are not the first choice.

Economy on Strong Footing

While the situation in Ukraine (and beyond) introduces uncertainties to domestic and global economic growth, the current economy remains on very strong footing. The New York Fed’s Weekly Economic Index (WEI) tracks a basket of ten daily and weekly economic indicators, and has historically been a good leading gauge of GDP growth (4-quarter moving average), as illustrated in Exhibit 1. WEI continues to hold above 5, and the most recent reading of WEI (February 19) was 6.84. That suggests an annual GDP rate 2-3x the pre-COVID trend rate for the US economy. This theoretically provides ample cushion for tighter monetary policy without materially impacting demand, but it remains uncertain how strong aggregate demand will remain in the face of higher inflation and tighter Fed policy.

Current forecasts from the Fed and private economists call for inflation and GDP growth to peak at some point this year. The Bloomberg median forecast has core PCE peaking at 5% year-over-year but not falling below 2.5% until Q2 2023. The median forecast for quarterly GDP growth peaks at 3.8% in the second quarter. Chair Powell has said they expect inflation to peak later this year, and the December 2021 Summary of Economic Projections (SEP) revealed a median participant projection for GDP and core PCE falling to 2.2% and 2.3%, respectively, by year-end 2023. An updated SEP will be released at the March 16 FOMC meeting, and in addition to forecasts for economic metrics, markets will also be looking closely at updated projections for the fed funds rate in 2023 and beyond, particularly the long-run projection. Regarding the latter, the last SEP had the long-run (or neutral) fed funds rate at 2.5%, and current market pricing has the fed funds rate peaking at just under 2% in 2023.

As noted previously, financial market volatility will likely remain elevated until there is more clarity on the Fed’s intentions and the geopolitical turmoil in Europe. The Fed could provide more guidance at the March 16 meeting, but Powell is likely to resist committing to any predictable path of rate hikes as experienced in the last cycle.

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