(Bloomberg) - The combination of strong US growth and sticky inflation is raising the odds the Federal Reserve hikes rather than cuts interest rates, bringing borrowing costs to as high as 6.5% next year, according to UBS Group AG strategists.
While the bank’s base case is for two rate cuts this year, UBS now sees a growing possibility that inflation fails to decline to the Fed’s target, spurring a pivot back to hikes and sparking a deep selloff in bonds and stocks. Markets have already scaled back bets on policy easing as recent US data has shown surprising strength in the world’s biggest economy.
“If the expansion remains resilient and inflation gets stuck at 2.5% or higher, there would be real risk the FOMC resumes raising rates again by early next year, reaching 6.5% Fed Funds by mid-next year,” said UBS strategists including Jonathan Pingle and Bhanu Baweja in a note.
The call shows how major banks are coming to terms with the possibility that the most aggressive hiking cycle since the 1980s — taking the Fed’s rate to 5.5% — might not be over just yet. UBS has already tempered an aggressive view for 275 basis points of US cuts this year, to now forecast just 50 basis points.
Its so-called “no landing scenario” of more rate hikes would prompt a sharp flattening of the US Treasury curve as benchmark yields move “meaningfully higher,” as well as a 10%-15% slide in equities, the strategists projected.
The call followed stronger-than-expected US inflation data last week, and came ahead of US retail sales Monday that also topped estimates. That’s made for a string of hot data points, fanning concerns that inflation is becoming entrenched. Traders have drastically pared bets on Fed easing to price 41 basis points by December, down from 150 basis points at the start of the year.
“Investors are in the early stages of worrying about an economy that may be running too hot,” the UBS strategists said. “In a high inflation scenario we would expect both government bonds to selloff and credit spreads to widen, making for a big catch down in multiples.”
By Alice Atkins
