Column-Fed Drops, Markets Consider 6% Risk: Mike Dolan
Reuters reports from London.Prices on the market tend to swing back and forth like a pendulum around what will happen in the end. Investors may now have to get ready for another difficult time figuring out how high U.S. interest rates could go.
Best bets on the money market at the peakThis month, Federal Reserve rates went back up after readings on jobs and inflation in January showed that they were tighter than expected. A 6% top that used to seem almost impossible has now crept onto the edge of the risk radar.
A Fed policy rate peak of 6%, which is more than 150 basis points higher than the current target and 75 basis points higher than what the futures market is currently assuming for the final rate, is still a long way from the current consensus, which is in line with the central bank’s own central assumption of 5.0–5.25%.
But most of these forecasters admit that the balance of risks in their predictions for peak rates is now even more on the high side. Traders who had planned on a final rate of less than 2% a little over a year ago are now considering all possibilities.
The jobs and inflation numbers for January have stopped the markets from undershooting the Fed’s “dot plot” guidance. This is a change from the months before, when the futures market doubted both the need and willingness to tighten that much.
It’s been a wake-up call for a few weeks.
The markets are now predicting a peak of 5.25% and, just as important, that rates will still be above 5% by the end of the year, which is at least one rate rise higher than where they are now.
At 4.65%, the yield on a two-year Treasury note hit its highest level in three months. This rate is now the same as the Fed policy rate.
Thoughts of credit getting easier from where it is now are being taken off the table bit by bit. This was a big part of the early-year market optimism.
As the chances of a recession in 2023 go down, Fed policymakers are talking tougher, and Vice Chair Lael Brainard is leaving the board, which is a big change in tone.
The chief investment officer at Glenmede, Jason Pride, said that the update on inflation hurt the “immaculate disinflation” story.
Matthew Hornbach of Morgan Stanley (NYSE: MS) called the payroll report a “mood-changing” print. As a result, markets have chased rates higher, as if they were afraid of missing out on something.
Just last week, JPMorgan (NYSE: JPM) CEO Jamie Dimon said that if inflation stayed “sticky,” the Fed could raise rates above 5%. “Everyone should take a deep breath before calling this a win,” he said.
And some traders look like they are taking very big breaths.
Last week, news spread about swaps and options trades on the Chicago Mercantile Exchange that bet on market rates reaching 6% or hedged against that possibility.
It looks like the pendulum has gone back to the other end.
For many Cassandra-like analysts who have been worried about big Fed rate hikes for over a year, this makes some sense, and the re-pricing may have even more to go.
Olivier Tadesse, a quantitative analyst at Societe Generale (OTC:SCGLY), has made a model of how much tightening he thinks the Fed will need to do to stop this round of inflation. He did this by combining the effects of rate hikes and quantitative tightening (QT), which is when the Fed runs down its bond portfolio.
The main point of Tadesse’s original analysis from last year was that 900 basis points of overall Fed tightening would be needed to get inflation back to target. Half of that would come from a huge $3.9 trillion of quantitative easing (QE), and the other half would come from 450 basis points of rate hikes.
But if the Fed’s balance sheet reduction stays at $95 billion per month and only adds up to $2.5 trillion over the cycle, he says the policy rate may have to go much higher, possibly as high as 6.5%.
So why haven’t stock markets gotten scared?
Part of the reason is that most funds are still underweight in stocks after a rough 2022.
Most of the time, however, it is because most investors do not believe in that extremely hawkish possibility.
In its most recent monthly survey of fund managers around the world, Bank of America (NYSE:BAC) found that less than 5% of respondents expected peak rates to be higher than 5.5%, with the majority agreeing that rates will peak around 5.25%.
Monica Defend is the head of the Amundi Institute. She says that when their economic models were tested with a 6% peak Fed rate, they showed that it would do a lot of damage to the real economy and probably cause a recession, but it would be much harder to get inflation back to where it should be.
She thinks that the Fed “won’t risk it” because of this difference, and she agrees with the current assumptions that the top rate will be 5.25 percent.
If that’s true, the fight over the terminal rate may now be overshadowed by how long the Fed can keep rates higher to reach its goals. And, depending on how well the economy does, this could make 2024 just as bad as this year, since there are no more chances of easing in sight.
These are the thoughts of the author, who writes a column for Reuters.
(Written by Mike Dolan, who tweets as @reutersMikeD; John Stonestreet made some changes.)