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The Fed is ‘as hawkish as they can be’ following major rate hike: Portfolio manager

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RJ Gallo, senior portfolio manager at Federated Hermes, joins Yahoo Finance Live to discuss the latest FOMC decision and what it says about the Federal Reserve's hawkish stance on inflation.

Video Transcript

RACHELLE AKUFFO: All right, well, now let's take a look at what the Fed's rate hike is going to mean for mortgages and the housing market, some factors that we've been taking a close look at. We're going to bring in RJ Gallo here, Federated Hermes senior portfolio manager. Thank you for joining us today, RJ.

So I first want to get your reaction here. Obviously, we have this now on the table. We're still waiting to sort of get the details of the press conference from Fed Chair Powell. What should people expect, though, once they hear this headline number out at the moment?

RJ GALLO: Well, I think the important thing that is behind us is this debate of 50 versus 75. I think that was a pretty seminal moment when the Federal Reserve used the mainstream business media to essentially plant that they had altered their forward guidance just days ahead of a meeting. So now we know it's 75. We can move on from that.

I think what's most important is how Chairman Powell supports the summary of economic projections, the dots, so to speak. Now that's a powerful tool for the Fed. They can now communicate a projected policy path. It's not a promised path, but a projected one. It is hawkish. It has the Fed taking the Fed funds rate to 3.75 in terms of the median dot for year end 2023. Some suggest that these numbers might be a little stale because we believe the FOMC members submitted them before the June 10th print of the elevated CPI reading.

Nevertheless, there's a lot you can read from this in the sense that the Fed is committed to fighting inflation. They are not pulling back their talons. They're as hawkish as they can be. I think the fact now is that Chair Powell is going to have to back that up by remaining consistent on the podium. I think we're at a point now where inflation is viewed as the problem. The Fed holds the solution. And they have to stick to their guns.

If they somehow deviate in a dovish direction, it's not clear that the markets would react warmly to that at all, because that would merely allow inflation to fester and would only be solved with more tightening in the future, anyway.

SEANA SMITH: So, RJ, what does that mean for Fed policy going forward? Excuse me. We got the 75 basis point hike today. Expectation here to get to 3.8%, I believe, by the end of 2023. What does that look like?

RJ GALLO: Well, the good news is from a bond investor standpoint, we have sustained double digit losses in just about every major bond sector in the marketplace, down 10%, 11%, 12% across major Treasury corporate municipal bond indices, even worse for corporates, like 16% down. Why is that? Well, it's because the Fed signaled that multi-decade highs in inflation will only be dealt with by much more hawkish policy. They have to tighten and to do so drastically. The bond market has reacted.

Earlier guests have commented on how mortgage rates have reacted. That's because expectations for tightening were so clearly fueled by the Fed's commentary and actions that much of the tightening that you're seeing today, this 75 basis points, and what will come to that 3.75 or 3.8 at the end of 2023, that's reflected in the bond market's current valuations.

If, going forward, the economy slows down, which, clearly, it is, doesn't go into recession, however, and if inflation starts to behave much better than we saw on the most recent CPI print, then the Fed can follow this script. It's not a promise, but it's a script. And they can get close to 4% in the Fed funds rate. The bond market is pretty much priced for something like that. This could be the beginning of a calmer investment environment where bond holders, bond investors, don't need to be so afraid of taking duration risk. Of course, it's all contingent upon how inflation behaves going forward.

DAVE BRIGGS: I sense some skepticism in your voice. Do you think this will work in bringing down inflation? There are those that think we're headed to 9%. And quickly, on mortgage demand, now roughly half of what it was a year ago, what's the impact on the housing market?

RJ GALLO: Well, the skepticism you hear in my voice is borne of the fact that I'm a bond manager, and we've lost double digits for the first time in my career. You'd have to go back to 1982, I think, to have bond markets be quite as adversarial as they are right now. Back then, inflation was sky high, and we had a hawkish Fed under Chairman Volcker. We're reliving a little bit of history here. So my skepticism is borne of that experience.

I think inflation will start to decelerate. It's proven very thorny for anybody, whether it's an army of economists on Constitution Avenue at the Federal Reserve's headquarters, or whether it's portfolio managers in Pittsburgh like me. It's very thorny to forecast the exact turn in inflation. But with the economy slowing, with retail sales slowing, with many economic data points indicating that the economy is decelerating, it's only a matter of time where the inflation does start to cooperate.

Now, do we get all the way to 4% on the Fed funds rate? We'll see. There's a long history of the Fed tightening until something breaks. What is that something? How important is that something? If it becomes a systemic risk event, that could slow the Fed's actions. But as we stand now, we have a healthy financial system, too much inflation, and a hawkish Federal Reserve, and the markets are priced for that hawkishness. The housing market will slow the same way just about every asset out there has reacted to the Fed's shift in policy.

Bitcoin, bonds, stocks, you name it, they're all going somewhat down in price because the Fed had to go from a near zero interest rate policy with an expanding balance sheet to a rapidly alternative world, where rates are rising and the balance sheet is shrinking. So, yeah, housing will suffer. The good news? Housing is not propped up by massive speculative finance like it was back in 2006, '07, and '08. So I don't expect a housing slowdown to become a housing crash and a systemic issue, at least not at this point.

DAVE BRIGGS: Plenty of room there and low inventory as well. RJ Gallo, good stuff. Really appreciate that.