'Slower Doesn't Mean Lower' - warning from top banks on smaller rate hikes.

While the Fed is likely to slow the pace of interest rate hikes from December, it could raise borrowing costs for longer, according to major investment banks.

Key points: 

• The central bank is expected to raise interest rates by 75 basis points for the fourth time on Wednesday, raising borrowing costs to a range of 3.75%-4%
• The frequency and magnitude of rate hikes have slowed since December, and the market appears to have beaten expectations.
• Inflation remains stubborn, suggesting the Fed has little room to turn dovish and stop raising rates anytime soon, a negative sign for risk assets.

Risk assets including cryptocurrencies have recently sparked hopes that the Federal Reserve will forgo a massive rate hike that began in December to end a so-called liquidity crunch sooner than expected, heralding November. The 2nd will suffer the same blow.

However, big investment banks believe that the Fed may be opening the door for more sharp rate hikes, and that a possible shift to smaller rate hikes does not necessarily mean an early end to the liquidity crunch.

The Fed has raised borrowing costs by 300 basis points (bps) this year, sending risk assets into a frenzy. The central bank is expected to raise interest rates by 75 basis points for the fourth time on Wednesday, raising borrowing costs to a range of 3.75%-4%. That could herald a 50 basis point decline in December.

The frequency and magnitude of rate hikes have slowed since December, and the market appears to have beaten expectations. According to futures linked to the Fed's benchmark rate, traders expect the rate hike cycle to peak around 4.8%, down from the 5% final rate set two weeks ago. Bitcoin is up 10% in two weeks, while the U.S. dollar index is down more than 2%.

“The Fed won’t finish raising rates until data shows. Core CPI is at a cycle high, U3 unemployment is at a cycle low. Companies tell us their biggest challenge is hiring. China and the U.S. are decoupling. Capex is up. Food and energy are becoming scarcer. Inflationary pressures appear broad-based and increasingly entrenched. Short-term inflation expectations from surveys have risen. The Fed's job is not done," the strategists added.

Barclays' credit research team echoed a similar sentiment in its weekly report, saying the potential bias of small rate hikes does not imply a truly dovish turn.

However, inflation remains stubborn, suggesting the Fed has little room to turn dovish and stop raising rates anytime soon, a negative sign for risk assets.

Data on Friday showed that the Fed's preferred measure of inflation, the core PCE, rose 0.5% month-on-month in September, unchanged from August and up 5.1% year-on-year. That's well above the 2% annual inflation target. In addition, labor costs continue to grow at twice the rate of the past 15 years.

As a result, the Fed is likely to raise rates at a slower pace over a longer period, potentially raising borrowing costs to well above the market-priced final rate of 4.8%.

“The Fed will emphasize data reliance next week. They will receive two more NFP and CPI prints before the December meeting; if they stay hot, another 75 bps is coming, if not slowing to 50 bps It is possible," Bank of America strategists wrote in a weekly note to clients on Friday. "While the market desperately needs a pivot, a slowdown doesn't mean lower."

“The Fed won’t finish raising rates until the data shows. Core CPI is at cycle highs, U3 unemployment is at cycle lows. Companies tell us their biggest challenge is hiring. China and U.S. are decoupling. Capex increases. Food and energy are becoming scarcer. Inflationary pressures appear to be broad-based and increasingly entrenched. Short-term inflation expectations from surveys have risen. The Fed's job is not done," the strategists added.

BofA economists are pricing a more aggressive rate hike path versus Fed's September projections, which showed terminal rate peaking at 4.75%. (BofA) (Bank of America global research)

Barclays' credit research team echoed a similar sentiment in its weekly report, saying the potential bias of small rate hikes does not imply a truly dovish turn.

“The Fed needs to see inflation reversing and labor market conditions worsen before it becomes more dovish. So we think she might keep options in December, so we may see limited scope for further dollar declines and expect The dollar will see a full recovery this week," said Bakali Credit Research.

A recovery in the U.S. dollar could weigh on risk assets, including cryptocurrencies. Bitcoin tends to move in the opposite direction of the dollar.

MUFG Bank currency analyst Lee Hardman said in a note to clients on Tuesday: "If the Fed does slow the pace of hikes in December, it does not necessarily mean as well that the total amount of tightening delivered in the current tightening cycle will be less, although that will be the initial assumption."

"It could be that the Fed slows the pace of hikes but eventually keeps hiking for longer," Hardman added.

Expectations from other banks:

Danske Bank 

“It’s too early to be soft on the Fed, we expect 75bps of rate hikes and a dovish communication. The Fed will raise rates another 150bps this year and then stop.”

ING 

"While we may be able to 'reduce' the pace of tightening from December, it is clear that inflation is far from being beaten and the risk is that rate hikes could continue for longer."

SEB group 

We expect Fed Chair Jerome Powell to reiterate that policy depends on data and through the meeting, but at some point, it may be appropriate to slow the pace of rate hikes, so in December the FOMC will release new economic and rate forecasts. "