Too many bulge bracket firms are dismissing the chance of a 75 basis point increase by the Fed tomorrow. Variance of expectations means greater potential for volatility (i.e. downside risk).
Over the weekend we stated that we believe there is a 50% probability that the Fed will raise its Fed Funds Rate by 75 basis points and a 25% probability that the Fed will raise by 100 basis points on Wednesday.
Equally important will be the pace and duration of the Fed’s QT program, which is scheduled to hit its $95 billion per month run rate in September. The Fed’s QT program shrinks the money supply which will dampen economic growth, but with a lag. Readers know that we believe the U.S. is in a recession now. The economic risk is that the more the Fed tightens monetary policy through rate hikes and paring the balance sheet, the greater the risk of a deeper and prolonged recession as tightening effects will persist beyond policy actions.
Our view of the economic end-game is long-term inflation of approximately 4% (double the Fed’s long-term target rate) and Real GDP of approximately zero. Institutional investors will need to recalibrate long-term equity return expectations given this new CPI normal which we expect the Fed to formalize within the next year.