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Fed’s aggressive rate hikes ‘quite telling’ of its inflation stance: Strategist

Eric Theoret, Manulife Investment Management global macro strategist, joins Yahoo Finance Live to discuss the outlook for the Fed meeting next week, the central bank's narrow focus on inflation, and the move in currencies.

Video Transcript

JARED BLIKRE: We want to continue the market conversation as investors look ahead to next week's Fed meeting. 75 bips, well, that looks like a lot. But money markets haven't discounted the chance of a full percentage point move. That would be 100 basis points.

Let's bring in Eric Theoret, Manulife Investment Management Global Macro Strategist. So let's talk about that Fed-- big meeting next week. We know what the expectations are. But lots of permutations that could evolve. What are you expecting here?

ERIC THEORET: Well, I think the most important release that we got this week was, of course, the inflation report. And again, I think your colleague just mentioned how sticky the core measure was. And so I think in a world of elevated headline inflation, sticky and elevated core inflation, we're in a world where the Fed needs to continue to tighten aggressively.

And so I think those looking for a pivot over the past several months have really been disappointed. And the fact that we have another unusual sized 75 basis point hike is, I think, quite telling that the Fed is very much focused on inflation. The dual mandate right now is really just solely a single mandate, given where inflation is.

And the Fed needs to tighten. I think on top of the, I guess, aggressive size of the cuts that we're obviously looking for next week, I think the other piece that's really going to come into the conversation next week is also the terminal rate-- so where the Fed sees its endpoint in terms of where it will be comfortable leaving the policy rate at the end of this tightening cycle. And I think where we had maybe expected the upper-3%, potentially 4% range, I think the message going into next week is really one where we'll have to see a policy rate going above 4%.

JARED BLIKRE: And I've seen 4.25% easily floated by a number of deaths, and then 4.5% as well. And let me pull up the YFi Interactive, I'm going to get a read of the bond market here. Here's the 13-week T-bill yield. This has been climbed-- basically, it's doubled over the last three months.

That's a huge feat in and of itself. But you can see that is only at 3.08%. And if the Fed's terminal rate, that's going to be a short-term rate that closely tracks this 13-week T-bill rate-- we've got a long way to go for the 13-week. That's a full percentage point above that.

And then we look at what's happened when it has risen very quickly before, that's been-- all that bond market volatility has seeped into the equities market. So it looks like we're not quite at the end of this cycle, no big surprise there. But how much more pain could we see in the risk markets as a result?

ERIC THEORET: Well, I think that's the key point, right? It's the dynamic between risk aversion and sentiment, and how that impacts financial markets, and then, of course, the expectations around interest rates. So I think that pain piece is critical. And of course, we've had the Fed frame out how they're looking at the labor market.

Obviously, very tight right now, obviously quite a bit of demand when we look at things like job openings. And when you consider their Beveridge curve framework-- they just want to reduce demand without actually creating additional supply in the form of a higher unemployment rate. But we haven't seen that much pain in the economy yet.

And I think that's the piece is we need to see a bit more of a slowdown in terms of growth in order to get inflation under control. And beyond the economy, obviously, we look at inflation expectations in markets as well. And I think it's really important to note that the 10-year break-even level is still at 2.4%. So we've got quite a bit to go to bring down those market-based measures of inflation expectations for the Fed to really declare victory on their price stability mandate.

JARED BLIKRE: And you're talking about pain-- a lot of pain has been felt and caused by the dollar. The US dollar very much strengthened. And let's call up the YFi Interactive once again. This is the US dollar versus a bunch of other pairs around the world.

Everything is versus the US dollar. So that would come first. But here we see in the upper left, the biggest gains have been made versus the yen. And this has been an incredible story. I'd just like you to comment.

We've also seen an incredible appreciation with respect to the Chinese Yuan. We're going to get to that in a little bit. But just wondering, at what point do some of these other central banks, maybe the Bank of Japan and PBOC over in China, at what point do they capitulate and maybe rein in some of that easing, maybe in one fell swoop? We've seen these things happen before.

ERIC THEORET: Yeah, absolutely. I mean, I think we have to separate the two because, obviously, they are two very different central banks and different economies. I think for the Japanese yen, you would typically expect to be performing in an environment such as this. The Japanese yen is a safe haven currency.

And yet, we've seen it trade completely on the back of interest rate differentials and completely separate from the sentiment piece, which would typically be beneficial for it at this point. We do have the Bank of Japan next week. For now, the governor has been very clear that they will continue their yield control policy, basically keeping a range for the 10-year yield in Japan at the upper limit of 25 basis points.

But I think, again, given the weakness that we've seen in the currency, the challenging dialogue that we've seen between the government and the central bank, I think there is the risk of a surprise. I think in terms of China, China continues to embark on their Zero COVID policy, and that's a very challenging policy to deploy from an economic growth perspective. And so I think so long as economic activity remains constrained in China, you will need to see accommodation there to provide an offset to those pretty aggressive headwinds.

JARED BLIKRE: We have time for one more here-- a global recession, how bad does it hit in the US potentially?

ERIC THEORET: Well, I think the challenging part right now is that, again, given China's Zero COVID policy, we've already had pretty aggressive growth headwinds in China and emerging markets more broadly. Obviously, Europe's entered a very challenging period as a result of the war in Ukraine and the energy crisis.

And now, you do have this Fed tightening that's starting to weigh on the US. So I think it's really a question of the US actually catching down to where the rest of the world has been already.

JARED BLIKRE: All right, we're going to have to leave it there-- really appreciate your thoughts on all these matters. Eric Theoret, Manulife Investment Management Global Macro Strategist.