The Federal Reserve’s next cycle of interest rate hikes is approaching, but might not look like what officials predicted
The Federal Reserve’s first cycle of interest rate hikes since 2015-18 is in sight, with a take-off expected next year, though it may look different than policymakers have imagined, according to investors and analysts.
Traders are now banking on a more aggressive start to the likely central bank monetary policy tightening campaign given persistent inflation and, in some cases, a relatively quick end to rate hikes as well. In one of the two most dynamic scenarios among Eurodollars traders, some believe the Fed funds rate target may not exceed 1% until 2028. On Friday, just over two 25 point hikes base of the Fed were taken into account. by the end of 2022.
Many financial market players are already looking past a likely announcement at the Nov 2-3 Fed meeting that officials will start cutting their $ 120 million in monthly bond purchases. With the multi-month gradual reduction process seen as inevitable, the focus is now on the Fed’s most likely path with interest rate hikes, as expectations are also building for the Bank of England hikes rates by December.
Remarks by Fed Chairman Jerome Powell during a South African central bank-sponsored discussion on Friday suggested the Fed may move away from the focus on the transitional nature of high inflation. He said high inflation is expected to last until 2022, and “we need to make sure our policy is positioned to accommodate a range of possible outcomes.”
The markets reacted swiftly, with yields on long maturities falling faster than short-term yields briefly did during a so-called bullish flattening of the Treasury curve. Meanwhile, the S&P 500 SPX,
set back by a record and the Nasdaq Composite COMP indices,
slipped nearly 1% on Friday, but both still posted weekly gains as industrialists Dow DJIA,
completed at an all time high. Earlier today, traders’ expectations for inflation over the next five years surpassed 3% for the first time on record.
A persistent rise in global inflation as economies recover from the pandemic upsets forecasts for the likely direction of central banks in the coming years, leading to a revaluation of rates for the United States, the United Kingdom. United and Europe. Along with this so-called “initial loading” of interest rate hikes in most of the Group of 10 countries comes a fall in implicit terminal market rates, which represent the levels at which these rate hikes would end. according to Jonathan Cohn, director of rate trading strategy for Credit Suisse Securities in New York.
The most recent rate projections by Fed officials, released in September, envisioned a path in which policymakers might propose only one 25 basis point rate hike by the end of 2022, followed by three. increases in 2023 and three more in 2024. Officials also expected the federal funds rate target to climb to 2.5% in the longer term, from a current level of zero to 0.25%.
When it comes to thinking about how to price the Fed’s policy, “the market seems more and more divided,” Cohn said via email.
One involves a scenario in which the central bank makes a “policy error”, he said, where the “Fed feels compelled to make a series of hikes earlier than expected, and ultimately poorly timed, which hamper the recovery and thus reduce the upside. short cycle. The other scenario, although less likely by traders, is a reflationary scenario in which the Fed is able to keep raising rates until the range is reached. Federal funds target is over 3%, a level not seen since early 2008.
Friday’s price action shortly after Powell’s comments “certainly leans more toward a policy error, with the implied terminal rate falling and breakeven inflation turning around amid a substantial bullish flattening of the Treasury curve, ”Cohn wrote. “In this seemingly bifurcated context, volatility around the political trajectory is expected to remain high.”
Read: Market implied odds of Federal Reserve policy error drop to around 40%, says Credit Suisse
Policymakers around the world are withdrawing economic support, albeit at varying speeds, more than a year after the coronavirus pandemic plunged many countries into business and consumer lockdowns. Meanwhile, central bankers and financial markets have underestimated the persistence of inflation, driven by a multitude of forces, including labor shortages, the need for higher wages, increased demand for consumers and disrupted supply chains.
So far, the Fed has committed to letting inflation exceed its 2% target to offset several years of past low inflation, but after five consecutive months of annual inflation of at least 5% in the index consumer prices, fears of persistent inflation take center stage.
“We have had a decade in which no developed market could meet its inflation target, and 10 years of consistently undervalued inflation,” said Paul Ashworth, Toronto-based chief US economist for Capital. Economics. “Suddenly we have more inflation than we can handle and central banks are now facing a completely different problem than they expected.”
“There is some uncertainty as to the Fed’s reaction function, and exactly if or when officials will realize that what we are going through is not transient and could be quite lasting,” Ashworth said by phone. . He sees a greater likelihood that the Fed will be forced to delay take-off until early 2023 due to slowing economic growth, although “we freely acknowledge that there is a risk that officials will panic when they are realize that core inflation is not going to fall back to close to the 2% target next year.
Capital Economics, a London-based research firm, expects the Fed funds rate target to reach just 0.5% -0.75% by the end of 2023, well below median forecast of 1% of the Federal Open Market Committee and the consensus of economists surveyed by the Wall Street Journal.
Traders in so-called ‘fixations’, or derivative-type instruments implying where future gains in consumer prices are likely to occur, have reported that the headline CPI year-over-year will be 5, 9% in October and 6.4% in October. in November and December, according to Tim Magnusson, partner and senior portfolio manager at Garda Capital Partners LP in Minneapolis.
The October reading alone could be the highest level in over 30 years, and would come after policymakers and the one-year futures inflation market consistently misjudged the persistence of price pressures in the market. over the past year.
“Inflation is rising at a time when the Fed has said it should come down, so it may not be behind rates but will be behind in terms of thinking,” Magnusson said in an interview with MarketWatch.
“I believe we will get a first round of aggressive hikes, higher than what is expected today,” said Magnusson. “But whether the cycle is shallow or not depends on the fall in inflation. If so, the cycle will be shallow, but we won’t know until the middle of next year if it is causing damage beyond what the Fed can handle. “
The recent flattening of the Treasury yield curve, namely the spread between 2 and 10 year rates, is emblematic of the dynamics at play.
The curve flattened even though higher inflation expectations should give longer-term Treasury yields a boost, as an inflation premium is built in. Instead, long-term returns such as the TMUBMUSD10Y 10-year yield,
either do not rise as fast as short-term rates or fall relative to them, causing the curve to flatten. The two-year rate TMUBMUSD02Y,
climbed to another 52-week high of 0.464% on Friday in anticipation of the Fed’s rate hikes, which is to be expected.
Analysts attribute the flattening of the curve to a number of factors. They range from traders simply needing to get out of unprofitable “firming” transactions to the idea that rate hikes will only hamper the recovery of the economy, as well as a more benign opinion than the economy. will probably slow down anyway.
The “initial loading” of rates for the US, UK and Europe occurs on “the significant risk that the timing, not just the pace, of hikes will have to change,” according to Credit Suisse’s Cohn. As of this week, the Bank of England is expected to rise about 1.5 times by the end of the year, the European Central Bank is expected to achieve a full 25 basis point hike by the start of 2023, and the Fed was considered to increase in total at least 4.5 times through 2023, he said.
Next week’s US economic calendar offers little new data that could change market thinking. Tuesday brings the October Consumer Confidence Index and housing market data. September’s durable goods orders and a preliminary merchandise trade report are expected to be released on Wednesday.
Weekly claims for unemployment benefits and readings of pending home sales and third quarter gross domestic product arrive on Thursday. Week ends with Friday data on personal income, consumer spending, core inflation, the Chicago Purchasing Managers Index and the University of Michigan consumer sentiment report .
Companies expected to report earnings in the coming week include Kimberly-Clark Corp., KMB,
; Eli Lilly & Co. LLY,
; 3M Co. MMM,
; United Parcel Service Inc. UPS,
; and General Electric Co. GE,