Upside From Higher Interest Rates vs Perceived Threat From Looming Recession
The Fed accelerated the tempo of rate hikes to quell inflationary pressure. We expect
another 75bp hike on 27 July but the intensity of hikes could ease after the FOMC
meeting on 21 Sep 22. The resilient labour market and strong households’ and
companies’ balance sheets in the US ensure that potential economic downturn, if it
materialises, would be mild. BUY DBS (Target: S$38.78) and OCBC (Target: S$14.95) for
their 2022 dividend yields of 4.8% and 4.9% respectively. Maintain OVERWEIGHT.
WHAT’S NEW
• Fed’s renewed fervour to clamp down on inflation. The Fed has accelerated the tempo
of interest rate hikes to quell inflationary pressures. It hiked the Fed Funds Rate by a
massive 75bp to 1.50% after the FOMC meeting on 15 Jun 22. Based on the Fed’s dot plot,
the median projected path for Fed Funds Rate would hit 3.4% by end-22 and 3.8% by end23. The forecast translates to four hikes totalling 200bp in 2H22, and we expect another
75bp hike on 27 July. The rate hikes are front-loaded in 2022 and the intensity of rate hikes
could ease after the FOMC meeting on 21 Sep 22.
• Interest rates in Singapore have moved up in tandem. Higher inflation and the Fed’s
intervention have caused short-term interest rates to surge. The US yield curve has
flattened, indicating a slowdown in economic growth. Fortunately, the 10-year – 2-year term
spread has stayed marginally positive at 0.1%. The current short-end of the yield curve
implies forward short-term interest rates at 2.7% for 1Y, 3.4% for 2Y and 3.4% for 3Y. 3-
month SIBOR and 3-month Compounded SORA have risen 112bp and 53bp respectively to
1.56% and 0.72% in 1H22. UOB Global Economics & Markets Research forecasts 3-month
SIBOR and 3-month Compounded SORA to reach 2.75% (+2.31ppt yoy) and 2.29%
(+2.10ppt yoy) respectively by end-22.
• Core PCE inflation is receding but at an anaemic pace. US core PCE inflation peaked at
5.3% in Feb 22, the fastest pace in 30 years, overshooting the Fed’s target of 2.0%. Since
then, core PCE inflation eased 0.3ppt mom to 4.9% in Apr 22. The easing of inflationary
pressure coincided with the pick-up in economic activities after daily new cases of the
Omicron variant subsided. Implied inflation based on 5-year Treasury Inflation-Protected
Securities (TIPS) moderated from a peak of 3.6% in mid-April to the current 2.8%.
• Chairman Jerome Powell said that the Fed needs to see compelling evidence with inflation
consistently abating over a couple of months before it pulls back from aggressive rate hikes.
The Fed needs to prevent expectations of higher inflation becoming unmoored. President of
Cleveland Fed Loretta Mester cautioned that it will take a few years to bring inflation back to
2%.
• US economy slipping into recession is not a certainty. The US economy is resilient with
a strong labour market and unemployment rate near a 50-year low of 3.6% in May 22.
Companies added 390,000 jobs while average hourly earnings grew 5.2% yoy in May 22.
There are 2.1 job openings for every unemployed worker. The resilient labour market
supports continued growth in domestic consumption to weather the series of interest rate
hikes. Households’ and companies’ balance sheets are strong, ensuring that the potential
economic downturn, if it materialises, would be mild. The probability of a US recession in
2023 is only 4.1% based on an indicator developed by the New York Fed.
ACTION
• QT has already begun. Quantitative tightening (QT) commenced on 1 Jun 22. Monthly cap
for treasury securities was initially set at US$30b and increases to US$60b after three
months. Monthly cap for mortgage-backed securities started at US$17.5b and increases to
US$35b after three months. The pace of QT is much faster compared to the monthly cap of
US$50b for the last QT conducted in 2018 and 1H19 when the Fed’s balance sheet
contracted 16%.
• Manageable impact from QT during 2018 and 1H19. We analyse the impact of QT on the
share price performance of Singapore banks during 2018 and 1H19, the only historical
precedent of QT. We observed that banks’ share prices gained 24.1% and outperformed the
STI by 15.9% over three quarters during 2H17 (the six months prior to QT) and 1Q18
(commencement of QT).
• Maintain OVERWEIGHT. Banks gain bargaining power as liquidity is tightened due to
higher interest rates and QT. They benefit from NIM expansion with DBS being the most
sensitive to higher interest rates. The Russia-Ukraine war exacerbates higher inflation,
which could keep bond yields higher for longer. OCBC and UOB benefit from reorientation of
supply chains towards ASEAN countries. BUY DBS (Target: S$38.78) and OCBC (Target:
S$14.95) for their 2022 dividend yields of 4.8% and 4.9% respectively.
DBS (DBS SP/BUY/S$30.21/Target: S$38.78)
• We expect DBS’ NIM to expand by 9bp to 1.54% in 2022 and 43bp to 1.97% in 2023. We
forecast earnings growth of 15.9% in 2023 and 9.7% in 2024.
• We expect DPS of S$1.44 in 2022 and S$1.48 in 2023, which represents dividend payout
ratios of 56.4% and 50.0% respectively. DBS provides dividend yields of 4.8% for 2022 and
4.9% for 2023.
• Our target price of S$38.78 is based on 1.69x 2023F P/B, derived from the Gordon Growth
model (ROE: 13.3%, COE: 8.5% (previous: 8.25%), growth: 1.5%).
OCBC (OCBC SP/BUY/S$11.39/Target: S$14.95)
• We expect OCBC’s NIM to expand by 6bp to 1.61% in 2022 and expand 27bp to 1.88% in 2023. We forecast earnings growth of 11.0% in 2023 and 6.1% in 2024.
• We expect DPS of S$0.56 in 2022 and S$0.60 in 2023, which represents dividend payout
ratio of 50.2% and 48.4% respectively. OCBC provides dividend yield of 4.9% for 2022 and
5.3% for 2023.
• Our target price of S$14.95 is based on 1.20x 2023F P/B, derived from the Gordon Growth
model (ROE: 10.1%, COE: 8.5% (previous: 8.25%), growth: 0.5%).
SECTOR CATALYSTS
• NIM expansion in 2022 and 2023, driven by upcycle in interest rates.
• Strengthening of economic growth driven by easing of safe distancing measures and
reopening of international borders after Singapore has weathered the Omicron variant.
ASSUMPTION CHANGES
• We raised our 2023 earnings forecast for DBS by 7% and OCBC by 3%. Our earnings
revisions are tempered by expectations of higher credit costs of 27bp for DBS (previous:
22bp) and OCBC (previous: 24bp) due to slowdown in economic growth in 2023. We have
factored in US Fed Funds Rate reaching 3.25% by end-22 and stabilising thereafter in 2023.
RISKS
• Escalation of the Russia-Ukraine war beyond Ukraine.
• Geopolitical tension and trade conflict between the US, China and Russia.