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Navigating Downside Risks, Upside Surprises With Rising Rates

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With global economic uncertainty at the forefront, many investors are still pricing between four and six Federal Reserve rate hikes in 2022 and another couple in 2023. But that pricing for Fed rate hikes is best understood as the center of a probability distribution that rates could rise more or less than investors currently expect. So, what are the major upside and downside risks with respect to rates?

Upside Risks

One major upside risk is that over the past four tightening cycles, bond investors have underestimated the actual number of Fed rate hikes by anywhere from 75 to 175 basis points.

Graphic: Fed Funds and Core PCE Inflation

Graphic: Fed Funds and Core PCE Inflation

Also, consider that all the rate hike cycles between 1994 and 2018 happened in the context of low stable inflation. With inflation currently running at over 7%, a tight jobs market, and rising wages, it’s easy to imagine persistent inflation forcing the Fed to raise further.

Downside Risks

But there are also downside risks. First, any equity market correction or a steep selloff in the corporate bond market could hold the Fed back from raising rates as much as investors expect. Second, geopolitical risks and higher commodity prices persist. On the one hand, higher commodity prices are likely to push inflation higher in the short term, but they can also hurt consumer spending and slow growth. Rising prices for food and energy might cause the Fed to slow rather than accelerate rate hikes. 

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