After the recent strong US employment numbers, fixed income markets hope to see at least small signals that inflation pressures are cooling off. But it will take more time before the economic cycle takes a decisive turn towards softer numbers. The interest rate tightening cycle has yet to truly damage the US economy, says Hendrik Tuch, Head of Fixed Income Netherlands at Aegon Asset Management.

“Taking into account that the Fed took the official rate to a neutral level of around 2.5% last month and has yet to turn restrictive, it is clearly too soon to declare an end to the rate hike cycle”, Tuch comments. “Financial markets, however, are not very patient. The Fed is trying to navigate the economy out of a dangerous period of overheating, but the only question it gets from the market is when it will stop hiking”.

“After the previous meeting, chairman Powell should have provided a clear answer to markets that the Fed is nowhere near done with hiking, but instead he left it to the market to guess the remaining length of the trip. Financial markets were allowed to think the Fed’s cycle was close to ending and even speculate that the Fed will cut rates considerably next year. The last two rate hikes of 75 basis points were meant to tighten financial conditions, but all the Fed got was a rally in bond and equity markets in July which completely negated the effect of these rate hikes”.

Tuch continues: “Since the start of August, Fed board members are trying to undo the damage of Powell’s press conference by emphasizing that the Fed is not nearly done with its tightening cycle. But a lot more needs to be done by the Fed to convince markets that it is committed to bring inflation back to a normal level expediently”.

On the need to convince markets that the Fed is not done hiking rates, Tuch adds: “Another 75-basis point hike in the September meeting would certainly help, especially in combination with a clear statement that the Fed is aiming to keep financial conditions tight for a considerable period. Such a statement will help markets to realize that any premature bond or equity market rally will just result in more rate hikes.”

He concludes: “Most investors are clearly still in the mindset of the previous decade that monetary policy will remain loose forever and that rate hike cycles will be shallow and short. In the coming quarters, this view will be challenged by central banks who must reclaim their credibility in fighting inflation”.