Will Fed policy become more favorable to market in 2nd half? Not now
By Jimmy Zhu
Wall Street in the Financial District of Lower Manhattan in New York City, the U.S. /CFP

Wall Street in the Financial District of Lower Manhattan in New York City, the U.S. /CFP

Editor's note: Jimmy Zhu is a chief strategist at Fullerton Research. The article reflects the author's opinion, and not necessarily the views of CGTN.

Recent falling commodity prices raise the hopes that inflation in some developed economies could peak in the second quarter. Even with that, the Fed will not likely slow down the tightening pace in the near term. Such action may delay the recovery in U.S. bonds and stocks but continue to support the greenback.

The sharp decline in commodity prices, including oil, in June, means that inflation should ease in June. The main reason behind the commodity prices' drop was mainly due to 'recession trades' as investors were worried that the U.S. Fed's tightening measures would ultimately drive the largest economy into recession. Such fears led to a strong dollar and a weak stock market, driving commodity prices lower last month.

Even if the June inflation data to slow down due to drops in oil prices, it might not be sufficient to convince the Fed that inflation in the U.S. has peaked. While the oil supply is expected to remain tight in the second half of the year due to major refiners' unwillingness to boost production, crude prices are likely to reverse lower significantly. Since late 2020, U.S. inflation has fluctuated with the movement of crude oil prices. 

Furthermore, the resilient U.S. jobs data for June released last Friday may help clear away some of the imminent recession fears, while the unemployment rate at 3.6 percent offers more room for the Fed to tighten the monetary policy to put inflation under control aggressively.

Against this background, the Fed is likely to raise policy rates by another 75 basis points in July, taking the policy rate to 2.25-2.5 percent, the highest level since 2018. Whether the pace of hiking will slow down from the September meeting will depend on the upcoming inflation data. We estimate that there will be another 100bps rate increase from September to December, setting the policy rate at around 3.5 percent at the end of 2022.

Impact on U.S. financial markets

Some market participants are worried that there would be another sharp gain in U.S. 10-year government bond yield amid global central banks tightening after it surged 150bps in the first half of the year. Based on the Fed's policy outlook, such worries may be overdone.

If the prediction for the Fed's interest rate to stay around 3.5 percent by year-end is correct, the U.S. 10-year government bond yield shouldn't exceed 3.5 percent as well, which is currently trading around 3.10 percent. Moving into the second half, higher policy rates should start to cause a visible slowdown in the U.S. economy, which may have some downward effects on U.S. bonds.

Some key economic indicators show that rate hikes have already slowed the growth activities in the second quarter. The ISM manufacturing PMI dropped 4.1 points from March to June, the largest quarterly decline since the fourth quarter of 2018.

University of Michigan Consumer Sentiment Index slumped to a record low level in June, as higher inflation and interest rates drastically dampened consumers' outlook on the economy.

If both manufacturing and consumption activities lose steam, the 10-year U.S. bond yield, which tends to track the growth outlook, will find it difficult to climb higher. Our base-case scenario is that the 10-year U.S. bond yield may trade in the 2.9-3.4 percent range in the second half of the year. 

In the past 12 months, U.S. stocks have been tracking the movement of the 10-year government bond yield, as higher bond yields tend to pressure the stock price lower. The correlation between the yield on the 10-year U.S. government bond and the S&P500 has been at -0.64 since June last year.

If the prediction of no huge gains in bond yields in the year's second half is correct, the worst-selling in U.S. stocks could be over. However, we expect the stock market to remain volatile in the third quarter, mainly due to the uncertainty of upcoming earnings reports and the Fed's tightening policy. 

The U.S. second-quarter earnings report will be kicking off this week. In the past two years, resilient earnings have been one of the important factors driving the stock market higher. However, we expect more companies to issue more negative outlooks this time around as demand slows and prices rise.

In addition, market participants are still unsure whether inflation has peaked and how aggressive the Fed will be. The FOMC meeting in July, the Jackson Hole meeting in August and the FOMC meeting in September are all big events for the stock market with huge uncertainties. Until these uncertainties become clearer, investors will become more confident.

Regarding the U.S. dollar, we expect the currency to remain strong in the third quarter. The Fed will still be one of the most hawkish central banks in the coming months, and no other major central bank can match its tightening pace. Such an outlook would continue to support the dollar.

In Europe, its rate hike pace should be very gradual in the second half, even with its red-hot inflation, as the ECB would continue to pay high attention to balancing the inflation fight and growth defending. In this case, the possibility of a strong euro to pressure the dollar is low.

Opportunity in yuan-denominated assets

With little upside seen in global stocks and bonds in the near term, Chinese assets may continue to outperform given the more friendly growth policy and the relative low inflation environment.

Policy priorities in China are becoming more and more pro-growth in the second half of the year. The latest data shows that its June CPI grew 2.5 percent from a year ago, much lower than most economies in the world.

Its relative lower inflation environment gives policymakers more room to support the economy from monetary to fiscal, which could lure more capital inflows when global stocks and bonds face large uncertainties. 

At this point, we expect the People's Bank of China to keep the main lending rates unchanged for the third quarter since economic data has largely improved in recent months. That said, the yuan is expected to remain stable against the greenback, which could attract more inflows into the local capital market.

Instead, the Chinese central bank may continue to inject more liquidity into financial markets to encourage commercial banks to increase credit to the real economy. Credit data in the second half of the year may become an important gauge of growth. 

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