Macro Insights Weekly: The year of rising (real) rates
- We consider two scenarios:
- Scenario 1: Fed gets what it wants
- Rates stay high, economy soft lands, inflation eases somewhat
- Scenario 2: Market gets what it wants
- Growth, inflation and employment slow sharply; Fed cuts by 150bps+
Commentary: Fed versus markets
During last week’s post-FOMC press conference, Chair J. Powell made some nuanced arguments about being data dependent, with more hikes still on the table. But the market focused on his view that recent asset market rally did not constitute a major easing of financial conditions. A dovish undertone was detected both with respect to the terminal rate and the possibility of easing within the year.
The FOMC statement acknowledged the quickening pace of disinflation and the fact that substantial tightening has been implemented already. It follows from this that the ceiling for the terminal rate is capped and might well be hit in the next FOMC meeting. In his press conference, Chair Powell delivered a relatively balanced message, recognising that the cycle is not entirely over, but that there are emerging risks to the central bank’s preferred soft-landing scenario (housing market and bank lending weakening). Bottomline, the Fed is ready to pivot late this year, subject to price and jobs developments.
It seems to be us that there is a tug of war between two scenarios:
First, the Fed gets what it wants. This would entail annual average inflation easing to below 3% this year, but Fed officials are not convinced that it comes down to 2%. As real interest rates rise, the labour market would soften, but only modestly. Rising real rates would also push down real GDP growth, but there would be no recession, especially as consumption gets some support from continued rise in real wages. Money markets remain orderly even as quantitative tightening continues.
Around this benign scenario, Fed funds rate is held at 5% during 2Q to 4Q.
This scenario is not being bought by the markets presently. If this was considered seriously, long-term rates would be higher, and equity markets would be under sustained pressure.
Another possibility in this scenario is that the Fed keeps the option to raise rates and tighten financial conditions again if inflation doesn’t come down to 2% and growth/jobs surprise on the upside. This development would, without doubt, be negative for the markets.
Second, the market gets what it wants. The deeply inverted yield curve and declining inflation expectations, based on market-based indicators, suggest a very different outlook held by market participants. The scenario entertained is that of unemployment rising, growth falling, and inflation becoming a non-issue this year. A sharp Fed pivot would be warranted under this scenario as the monetary authority would be compelled to counter tightening financial market conditions. Quantitative tightening would be stopped, and policy rate cuts would begin either in 4Q23 or 1Q24. The pricing now is for over 150bps in rate cuts next year.
We don’t think a single FOMC member believes in this scenario presently. This is a stark illustration of the Fed’s credibility gap; a market that goes by the dictum of “don’t fight the Fed” is very much taking on the battle, rallying robustly in expectations of substantial rate cuts in the 9-15 months horizon. Quite the tug of war. We have some bias toward the Fed’s scenario, but we are also wary of Fed officials feeling the need to satisfy the markets.
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