The Last Fed Hike
What You Missed
Yields across the maturity spectrum fell, amid news of a near-uniform view among the Fed’s voting members that rates will go higher than markets believe, and that the Fed is nowhere near wrapping up its inflation fight.
For the week, the 2, 5, 10 and 30-year US Treasury yields fell a respective 20, 18, 17 and 8 bps. Overall, the continued drop in yields reflects the financial market’s belief that short-term rates are indeed going higher, but, in direct opposition to the Fed, that the US economy won’t be able to sustain higher rates for long.
Elsewhere, global equities fell on the week, while the price of a barrel of West Texas Intermediate crude oil also fell $1 to $74.29 from a week ago as the US dollar and Gold traded within tight ranges. The US 2-year vs. 10-year Treasury yield spread, a widely watched barometer of the likelihood of a looming recession, held near its most inverted level since the early 1980’s at -0.70%. Why do we focus on the 2-year vs, 10-year Treasury yield spread? The yield curve’s utility as a recession indicator is always a hot topic. It has an almost unblemished record of forecasting recessions, only giving one false positive in the postwar years. However, it is limited in its usefulness due to the variability between when the curve inverts and when the ensuing recession actually hits, which has ranged between six months and two years. Learn more about yield curves and what they mean here.
Hedging Costs Ease Further but Remain High
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its liquidity, backed off its recent all-time high of 4.53%, falling 3 basis points last week to 4.50%, along with short-term Treasury yields. The implied yield on the 3-month SOFR futures contract 1-year forward (December ‘23) fell 24 basis points from this time last week, also in concert with the fall in Treasury yields, to 4.51%. The SOFR futures market continues to imply that markets expect 3-month SOFR will peak in late spring 2023 – along with the Fed Funds rate – near 5.05%, followed by a gradual decline over the next three years as the Fed eventually eases. Finally, interest rate volatility, a key driver of the cost of rate caps and other option-linked interest rate hedges, reversed its recent ascent, falling to levels last seen in mid-August, dragging rate cap prices lower with it.
Fed Vows No Cuts in 2023
The Fed delivered a widely expected half-point rate hike last week, raising the upper-bound of Fed Funds to 4.50%, while also serving up some seriously hawkish forecasts for its peak Fed Funds rate and inflation. The Fed also raised its 2023 median forecast for where Fed Funds will peak, to 5.1%, higher than the September median of 4.6%. Despite softer inflation readings in recent months, the Fed justified its moves by raising its outlook for core personal consumption expenditure (PCE) inflation – the Fed’s preferred gauge – to 3.5% from 3.1%.
In his post-meeting press conference, typically where the real insight into the Fed’s thinking is garnered, Fed Chair Powell stressed that no one on the Fed’s rate setting committee envisions rate cuts next year, and that the Fed will continue to make monetary policy restrictive enough to bring inflation down to its 2% target. With Chair Powell’s statement, it’s clear that the surprisingly soft November CPI number (see below) just before the meeting didn’t change the Fed’s view on inflation: it’s too high and the Fed will keep hiking in the near term to smother it. Despite Chair Powell’s efforts at clear communication, financial markets aren’t buying it, showing price levels that imply doubts that the Fed will be able to raise rates as much as its claims nor hold them at peak levels for as long as the Fed is advertising.
One of the financial market’s “crystal balls” , inflation swaps, shows interest rates will exceed the inflation rate as soon as March 2023 and the Fed will end its tightening cycle in May 2023. Interest rates exceeding the inflation rate has been necessary in the past to finally bring prices under control, so, this time around, its seen as paving the road for Fed rate cuts. More on this in future editions of Straight to Smart.
In the meantime, we’re contemplating these three questons over the holidays: 1) What would it take for the Fed to believe it can engineer a soft economic landing? 2) Is it possible, in the short-term, for a strong jobs market and declining inflation to co-exist? 3) How many layoffs must happen before the Fed considers them to be too much?
Latest Inflation Gauge Establishes Case for a Pause
The headline consumer price index (CPI) posted an encouraging 0.1% increase in November from the previous month (+0.4%), falling short of the expected 0.3% and surprising markets in a good way. Year over year, inflation rose 7.1%, down from 7.7% in October. When converted to the Fed’s preferred gauge, PCE inflation, the headline rate is likely hovering around a mediocre 5.4% over the past 12 months. Elsewhere, the Federal Reserve Bank of New York Survey of Consumer Expectations showed that one year inflation expectations moderated to 5.2% in November, a 15-month low, from 5.7% in October.
Core CPI, a measure of inflation that excludes volatile food and energy prices, came in weaker than expected at 0.2% for November (versus 0.3% in October). This led to a surprise slowdown in the overall core CPI, which fell to 6.0% year on year from 6.3% in October. Base effects are expected to continue pushing nearly all gauges of inflation down in the coming months.
Shelter costs – a key driver of overall inflation and one that’s remained stubbornly high – increased by 0.6% in November (versus 0.8% in October), driven by a decrease in lodging costs for temporary stays away from home. However, rent for a primary residence and owners’ equivalent rent both picked up again from October.
Our take: The November CPI report was the second month in a row bearing good news on inflation, and December’s report, released in early January, will likely bring a third. November’s data builds on evidence that inflation is falling and will likely continue to do so. Factors such as easing supply constraints, discounts to clear excess business inventory, a downturn in interest-rate sensitive sectors, and lower energy prices have all helped the Fed in its efforts to contain inflation. Early signs indicate that price gains in December are also tracking at a similar, relatively low rate. We suspect the key shelter components to inflation to reach their peak soon, but don’t expect the year-over-year increase to peak until the first half of 2023. All told, by the time the Fed meets again, in late-January, some Fed officials may consider there to be enough “compelling” evidence to start discussing a pause in rate hikes.
Retail Sales Data Shows Fed Hikes are Working
Headline retail sales took a major hit in November, plummeting by 0.6% instead of the predicted contraction of 0.2%. Most of the decline can be blamed on auto sales, which tanked by 2.3% after a 1.6% increase in the previous month. Building materials also played a minor role in the downturn. These categories are both sensitive to interest rates, so their slump could be a sign that the Fed’s rate hikes are starting to choke off demand. In addition to the dump in auto sales, sales declines in other categories were widespread, suggesting that the drop is more than just payback for consumers pulling purchases forward to the previous month.
Our take: The underwhelming retail sales data shows that the Fed’s rate hikes are starting to pack a punch. With Chair Powell signaling at last week’s meeting that the central bank isn’t finished hiking rates and with consumers redirecting their spending from goods to services (which aren’t included in the retail sales report), the weakness in retail sales is likely to continue into the spring. A caveat: residual cash buffers from pandemic stimulus and wage growth will keep consumers resilient.
What to Watch This Week – More Signals on Inflation
With major events of the month mostly behind us, financial markets are careening swiftly towards holiday mode, with trading volumes getting lighter as the week drags on.
The Fed’s forecasts totally underestimated the upswing in inflation over the past year, and now they will likely underestimate how fast inflation will fall over the next few months. The Fed’s preferred measure of inflation, the core PCE deflator, needs to exceed most analysts’ forecasts in the last two months of the year to reach the Fed’s forecast of a 4.8% increase in Q4 2022. If November’s monthly report (on tap for this Friday) meets the current consensus, December’s will have to increase by 0.6% to meet the Fed’s year-end forecast, which we don’t think is likely given the fall in other inflation gauges of late.
Short-term inflation expectations (as measured by the University of Michigan’s consumer sentiment survey, also on tap for this Friday) are also declining rapidly. Financial conditions have improved since October and longer-term Treasury yields have fallen further – the 10-year is now down 34 basis points over the last month – after the weak November CPI report. This has led to lower mortgage rates, providing some relief for the housing market, which is the most sensitive sector to interest rates. We’ll get more clarity on housing via the release of the National Association of Home Builders’ report on Monday, housing starts on Tuesday, existing home sales data Wednesday, and finally, new home sales data on Friday.
The days ahead will also provide an updated peek into the state of household incomes, where its widely believed that various government policies – like Social Security’s 8.7% cost-of-living adjustment for over 60 million retirees, a one-time tax rebate from several state governments, and an extension of the student debt moratorium – are continuing to provide support. These unusual measures may mean that the Fed’s rate hikes are facing an economy that is more resistant to slowing down (initial jobless claims, Thursday and consumer confidence, Wednesday), encouraging the Fed to keep up the threat of more rate hikes, and a rate environment where rates stay higher for longer than markets expect.
Big Picture – Did we Just Witness the Last Fed Hike?
Markets expect the Fed to further downshift its rate hikes from 50 basis points to 25 basis points by July of next year. That seems like an awfully long time from now, and historically speaking, such a downshift could come sooner.
Looking back to 1972, the last Fed rate hike usually occurs about 22 weeks after the peak in CPI. In this current cycle, the peak in CPI was in June, which was 23 weeks ago. This would mean that the last Fed hike of this cycle happened last week. On average, the first cut usually happens about 16 weeks after the last hike, which in the current cycle would be in early April 2023.
Of course, there is no reason for history to repeat, and we doubt the historical conclusions above hold true this time around. We expect the Federal Reserve to downshift to 25 basis point hikes beginning in January and hike another 25 basis points at each of its policy meetings in February and March bringing the peak Fed Funds rate to 5.25%. Given that inflation, while falling, is still well above the Fed’s 2% mandate, more rate hikes are needed, and the Fed Funds terminal rate probably needs to be maintained for a lengthier time than markets are forecasting. The fly in the egg nogg? A sharp rise in unemployment, which would become unpalatable for the Fed if coupled with steadily declining inflation. Such a scenario would stop the Fed’s plans for more hikes dead in their tracks. Like we’ve been saying for weeks now, if you want to know where the Fed is heading, watch the jobs market.
As for rate cuts, we doubt we’ll see them until the fall of next year at the soonest. The risk of recession is increasing, even though one isn’t imminent yet. While the job market still looks good on the surface, there are signs of weakness, such as rising unemployment claims. There’s also a chance that the economic data we’re seeing now could be revised downward in the future. Even though the Fed has said it will keep policy tight for longer than markets expect, a sudden decline in the economic outlook could lead to a quicker policy reversal than many people expect.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
LIBOR Forward Curves:
1-month Term SOFR Forward Curve:
10-year Treasury Yield:
Source: Bloomberg Professional