Interest Rate Outlook: A Central Bank with Conviction
Derivative Logic’s look at interest rates during 2023
When you need to get somewhere quickly, it’s important to know where the road you’re on is likely to take you. Below we present our view of interest rates for the rest of this year. We support our analysis with some detail, so to get you up to speed as quickly as possible please begin with our Executive Summary below. Then dive into the rest of this article for detail. Total read time is 25 minutes.
The focus of our 2023 rate outlook is largely on Fed monetary policy, inflation, and the potential for financial market instability. Sluggish economic growth and the potential for a somewhat higher unemployment rate are less prominent considerations currently due to the Fed’s willingness to accept an economic recession and some cooling in the labor markets as key tradeoffs in its efforts to sustainably turnback inflation.
• US inflation pressures are cooling and the economy is slowing, just not as quickly as the Federal Reserve desires. The Fed remains determined to continue with its rate tightening campaign.
Underlying inflation pressures have not been eliminated and continue to pose downside risks to the economy and the financial markets.
•US Treasury yields (UST) past 5-year maturities are lower in the New Year so far and declines are modest. Short-term rates are higher, adjusting in anticipation of more Fed tightening. The UST yield curve is decisively inverted between 6-months and 10-years.
The yield curve currently marks a risk-free medium-term rate environment of ~ 3.75% – 4.50%. While this reflects short-term rates eventually coming down somewhat, it also suggests a medium-term rate environment that stabilizes above pre-covid levels for SOFR and term yields. One to 5-yr forward UST yields are also now at levels higher than seen before covid.
•We expect short-term rates to remain elevated in 2023 and agree with the market’s forward assessment that rates eventually stabilize above pre-covid levels.
We do not expect the FOMC to back off anytime soon from its anti-inflation, hawkish rate stance. FOMC members are speaking in unison over the need to lift rates further, and hold them high this year, to secure price stability going forward. We agree and see the target fed funds range ending the year above 5%. Resurgent price pressures are a key risk that the market only recently seems to be contemplating.
•The battleground between the financial markets and the Fed, however, looks poised to continue into mid-year delivering more market demands for the FOMC to eventually accommodate. The outcome is likely to lift rate volatility and keep the yield curve meaningfully inverted for the time-being.
•For 2023, we expect real US GDP to rise minimally, labor market tightness to ease further as the unemployment rate gradually rises, and for home prices to fall further, but modestly. We anticipate overall financial conditions to remain easier than the Fed would prefer as stocks fail to meaningfully correct and for term yields to retain only a fraction of their post-Oct’22 declines. Absent final demand pulling back deeply, which we believe would require significant job losses and notable wealth destruction in financial assets and housing, it’s going to be less likely (and take much longer) for US inflation to return to the Fed’s 2 percent target.
A Central Bank with Conviction: the near-term path for Fed Funds
Per the most recent FOMC policy meeting minutes, from the Dec 13-14 session, no meeting participants anticipated it would be appropriate to cut the fed funds rate in 2023 believing “substantially more evidence of progress,” confirming inflation’s downward path, was needed. The FOMC continued to anticipate that ongoing rate increases would be appropriate. The minutes reflected concerns that labor demand remained strong despite the slowdown in economic growth.
The FOMC is serious about wringing out inflation as the cumulative 450 bps of tightening since last March demonstrates. We expect the Fed to lift its funds target another 50 bps, spread evenly in 25 bp increments at the upcoming March 22nd and May 3rd 2023 FOMC policy meetings. In conjunction with this, we anticipate the FOMC will firmly signal a hawkish message into Q2 ‘23 and to subsequently transition to a ’hold’ scenario at a presumed 5.00% to 5.25% funds target range. The 5.125% midpoint here, that we expect, is in line with the FOMC’s most recent y/e ’23 guidance for its funds target, communicated in the Fed’s Dec 14th Summary of Economic Projections.
The Fed is not about to discard its tough talk. From an inflation risk perspective, the potential to force an unpopular recession still outweighs not tightening policy enough if the Fed is going to succeed at sustainably lowering price pressures … structurally tight labor markets measured by a historically low unemployment rate, robust payroll gains, and high job vacancies remain considerations despite the recent pickup in layoffs and some cooling in labor demand.
In Q2, the FOMC will likely aim to communicate only a very low likelihood of further rate hikes and a watered-down hawkish policy threat. At mid-year, a formalized holding period for the fed funds target will likely be communicated but shouldn’t necessarily be viewed as a pivot signal (to lower rates). Instead, we anticipate the Fed will express the need for patience so it can observe the full effects of its cumulative rate hikes. There’s a policy time lag to consider and it’s key to our outlook … we discuss below.
Beyond the fed funds policy focus, further FOMC tightening will continue in the background during H2 ’23. The Fed’s other key policy tightening tool, quantitative tightening, remains an important mechanism and will continue to allow for UST and MBS roll-off to slowly shrink the Fed’s $8.5 Tn balance sheet.
By Q4, we expect a mild pivoting signal from the FOMC indicating a 2024 policy shift (a tilt to ease) that sets in motion the potential for ~ 150 bps in rate cuts for next year. Our 2024 easing view exceeds the Fed’s most recent Dec 14th dot plot median outcome of 100 bps in ’24 rate cuts. Our more aggressive view on a 2024 policy easing reflects our expectation that next year faces a greater share of the economic burden imposed by the Fed’s cumulative rate increases as the lagged impact of tightening spreads out.
The time lag of rate hikes = more economic pain ahead
It is generally understood that monetary policy works with a 6-to-18-month time lag – in both directions. One estimate of these lags that we adhere to suggests that when Fed policy rate changes occur, it takes between 6 and 9 months for the intended economic impact to be felt.
According to our calculation, the cumulative 425 bps of Fed rate increases last year were equivalent to just 251 bps of ‘full-strength’ tightening as of y/e ‘22 … applying a time lag of 7.5 months (average of 6-9 months). Based on this degree of a lag, the ‘full effect’ from last year’s cumulative rate hikes does not occur until the end of July ’23.
If the FOMC delivers on the 50 bps of tightening they’ve likely penciled in between now and early May, as we expect – plus Feb’s recent 25 bp rate hike – the cumulative 500 bps of tightening would not achieve full effectiveness (given a 7.5 month lag assumption) until mid-Dec ‘23.
One year ago, the lower end of the fed funds target range was zero. A 500 bps shift in the funds rate over this timeframe is absolutely enormous and in our opinion warrants a greater appreciation for its ultimate economic impact. Combined with the continuation of the Fed’s balance sheet reduction, US monetary policy becomes increasingly restrictive as 2023 rolls on.
By y/e into next year, the weight of the cumulative tightening burden becomes a formative economic headwind. This is justification for the FOMC to ‘hold’ after the early May ’23 Fed decision. Factoring in the full lagged effect through mid-Dec ’23 (+500 bps) would be the equivalent of double the y/e ’22 lagged effect of 251 bps (noted above). This suggests Fed policy becomes disproportionately restrictive in 2023 beyond the 50 bps of additional rate hikes we expect through early May. Given this, we think any action on the part of the FOMC to lift its fed funds target range beyond 5.00% to 5.25% this year would be shortsighted.
CPI inflation: not returning to 2 percent
For years before the pandemic, we witnessed price appreciation in real estate and financial assets far outpace the inflation rate, wages, and the growth rate in the economy as leverage increased and the Fed aggressively accommodated. While much of that price appreciation is intact today, the pandemic unleashed such intense imbalances that pricing power away from real estate and financial assets had an opportunity to catch up … it was long in coming and just needed a catalyst which came from covid and lots of fiscal stimulus. The combination of the two, affected supply and demand in the worst direction possible on both sides.
Prices of goods, services, and labor overall have had an opportunity, over the past couple of years, to regain some serious lost ground. While we are clearly witnessing a significant moderation in goods price increases as pandemic-related imbalances dissipate, imbalances do remain and price pressures from labor are far more structural amid shifting demographics and other labor-related nuances such as mismatched skills and the level of labor market participation. Due to this, we do not see the Fed coming close to achieving its 2 percent inflation goal this year despite its efforts to get there.
Annual Inflation, however, has been cooling since mid-2022 and we expect further moderation as supply and demand forces better align. In this regard, we expect the YoY headline CPI to moderate by about 2.5 percentage points this year from Dec ‘22’s 6.5%.
As supply constraints related to the pandemic fade, inventories overall have been rising which has allowed for more price stability in goods and merchandise recently. A measure by the Census Bureau showed US wholesale inventories at 1.4 months of supply in Dec ‘22 (most recent), in line with pre-pandemic levels and up from a pandemic low of 1.2 months in Jul ’21. Auto & related parts inventories reflected 1.6 months of supply in Dec, up from a low of 1.2 months in May ’21, but well below pre-pandemic levels of 2.3 months. Overall retail inventories were at 1.26 months of supply in Dec, up from the pandemic low of 1.09 months in Apr ’21 compared to 1.45 months pre-pandemic. While retail inventories are moving up relative to sales, they are not yet back to pre-pandemic levels suggesting less urgency for retailers to offer discounts … behaviors that could have accelerated the pace of moderating inflation.
Despite the gains in some inventory categories, the latest CPI for January showed rapid price increases in a number of non-merchandise, more service driven categories including, utility costs (gas), shelter, auto maintenance, auto insurance and hotels … to name some.
Per our count, 27% of all detailed CPI expenditure categories had negative price changes last month offsetting a portion of the price pressures just noted. Negative monthly price changes, scattered within the CPI category detail, are not uncommon … we’ve been tracking them. In Q4 2022, 36% of all CPI expenditure categories had negative price changes. That was up from 28% in Q3 and 21% in Q2 (when headline CPI peaked). The extent of monthly negative CPI price changes in Q4 alone was impressive at 35% for Oct, 36% for Nov and 37% for Dec … months where enthusiasm over moderating CPI escalated, US interest rates fell as did futures market expectations for where SOFR and fed funds would be in H2 ‘23.
While the Jan outcome (27%) of negative price changes stands out as setback, we don’t see this as a turning point to inflation reigniting but rather another sign of variability in price changes. We will be looking to see how this pattern evolves … an increase in the number of categories experiencing negative MoM CPI outcomes would be commensurate with a broadening of inflation’s cooling and would suggest a greater likelihood of a formal FOMC mini-pivot away from its hawkish policy stance to ‘neutral’ past mid-year.
While we do not expect prices, in most expenditure categories, to return to pre-pandemic levels, we expect smaller price gains ahead leading to a lower annual rate of inflation. We do not expect the path of monthly price changes to moderate linearly as near-term inventory management and shifting wholesale inputs have their effect.
The Jan CPI showed headline figures up 0.5% MoM compared to 0.2% & 0.1% monthly outcomes in Nov & Dec. We do not view last month’s inflation pop as a sign that inflation’s YoY trend is heading back up, but rather as an indication that the recent pace of moderation leveled off a bit amid price changes in the New Year.
Volatile monthly inflation trends, even with annual CPI inflation heading lower, will spill over into the rates market and delay prospects for a Fed pivot that might usher in less restrictive monetary policy. While an expected non-linear path for CPI inflation is not necessarily abnormal, it’s likely to challenge the Fed’s confidence in believing inflation will stay down … that would work to delay any likelihood of a Fed pivot announcement until late this year.
We anticipate the YoY headline CPI, which was 6.4% in Jan after having declined for a 7th month, to end this year at roughly 4% as the lagged effects of monetary tightening intensify. We expect the Fed’s preferred inflation measure, the core PCE, to end the year lower at 3.6%.
Long-term inflation expectations are unsettled
Headline US inflation, measured in YoY annual CPI terms, has now slowed for 7 straight months. Over the past 4 months, the YoY core CPI has moderated. Near-term inflation expectations, which are forward looking, have eased as well compared to the middle of 2022.
While Fed officials have viewed longer-run inflation expectations as relatively stable, they also worry that expectations have a strong impact on where inflation is headed. The minutes from the Dec 13-14 FOMC meeting indicated that risks to inflation were “skewed to the upside”. Inflation expectations ultimately factor into such risks. The Fed is concerned that higher wage growth amid a generally tight labor market reduces the likelihood that inflation will return to its 2 percent target. We agree.
The 10-yr breakeven inflation rate, a measure of market-based long-term inflation expectations derived from 10-yr UST yields and 10-yr Inflation Protected Treasury yields, declined to 2.3% at y/e ’22 and is there currently. This compares favorably to 3.0% last April (highest since 1997). The value theoretically represents a real-time measure of what the market expects CPI inflation to be, on average, over the next 10 years. While this gauge is sometimes helpful to assess changes in L/T inflation expectations, often it can get pushed around by market considerations such hedging in the institutional bond market or by changes in investor demand for Inflation Protected USTs.
To complement market driven expectations such as this, survey measures of consumer inflation expectations are used for different future timeframes.
Among these measures, The University of Michigan’s consumer sentiment survey on expected price changes during the next year peaked last March (’22) at 5.4% … it’s currently at 4.2% while in January it had fallen to 3.9%, the least since Apr ’21. Expectations averaged 5.0% in 2022.
Consistent with the 1-yr Michigan survey, Dec’s FOMC meeting minutes highlighted that recent market and survey-based inflation expectation measures pointed “to expectations for a moderation of inflation over the coming year”.
What appears less clear, however, is looking at the longer-term expectations. While survey measures of L/T inflation expectations are not significantly above the Fed’s 2 percent preferred inflation target, they have moved up.
The U. of Michigan survey also captures sentiment over the next 5-10 years. In this survey, though inflation expectations are not nearly as high as the 1-yr above, they are also not moderating in the same manner. After peaking at 3.1% last Jan and Jun, expectations fell to 2.7% last Sept and have since moved up to near 3.0%.
While these differences don’t seem like much, the outcome may be significant because medium to long-term inflation expectations have risen since Sept … and compared to pre-pandemic levels, expectations are up over a half percentage point (Dec ’19 low of 2.2%). This measure averaged 2.5% from 2015 through 2019.
In another survey, there are somewhat similar dynamics between near-term and longer-term inflation expectations. The NY Fed’s Center for Microeconomic Data showed median 1-yr inflation expectations at 5.0% last month, in line with Dec, and the lowest outcome since Jul ’21 … this measure had peaked at 6.8% in Jun (’22) amid record high gasoline prices and it coincided with last year’s 9.1% peak in the YoY June CPI. The inflation mindset and expectations were then greatly impacted and reinforced by gasoline’s climb amid the high frequency exposure consumers had to its rising price.
We don’t expect a large spike higher in inflation expectations this year … Crude oil supply and gasoline stockpile dynamics are currently better than last summer, and we anticipate some relative price stability ahead despite shifting dynamics on Russia’s war in Ukraine and increased energy demand from China.
What’s also noteworthy regarding inflation expectations is that last year’s gasoline effect did not spill over into medium-term inflation expectations nearly as forcefully as it did with the 1-yr expectations. The survey’s most recent medium-term expectation (3-years) fell to 2.7% last month, the lowest since Oct ’20, and was 3.6% in Jun ‘22 when gasoline peaked. The survey’s latest 5-year expectation, however, showed signs of a modest pickup, increasing to 2.5% last month from 2.4% at y/e ’22 (was 2% this past Aug).
Elsewhere, the Philly Fed’s Q4 ’22 Survey of Professional Forecasters showed headline CPI expectations averaging 3.75% over 5 years (’22 – ’26), up from 3.50% in Q3. 10-yr inflation expectations increased to 2.95%, up from 2.80% in the Q3 survey.
Having confidence in the usefulness of survey data, when it comes to inflation expectations and forecasts, is tricky. Underlying current conditions and inherent biases – formed during the past – can have an impact on what’s to be expected.
When it comes to inflation expectations about the future, it’s possible that the duration of the 2021 – 2022 price surge was just too brief to have yet solidified L/T inflation fears … especially considering that low inflation and the frustrations that came with it, such as weak pricing power and low margins, were in place for such a long time (~ 15 years).
Our concern, the longer inflation expectations stay near current levels and the further away we get from that lengthy period of low inflation, the more likely it becomes that longer-term inflation expectations don’t fall but move higher. The consequences of this … more difficulty getting inflation back to the Fed’s 2 percent goal and keeping the Fed more concerned about possible upside inflation risks.
We consider long-term inflation expectations to be among the most important interest rate considerations to follow right now. If long-term survey-based inflation expectations were to rise above 3% this year (a level not that far away), we believe some senior Fed officials will push for further rate hikes past mid-year arguing monetary policy is still not restrictive enough.
Is unwanted inflation over with?
Unlikely. While supply and demand dynamics are becoming more balanced than during the past 3 years and inflation is cooling, the economy has entered a period where inflation risks are far greater than during the pre-covid period.
The Fed’s 2 percent inflation goal is going to be difficult to achieve without a deep US recession that significantly hurts the job market … an outcome we don’t see happening. Several changing dynamics within the economy are likely to keep price pressures more elevated than in the pre-covid period.
Consider the deep imbalances brought on by covid’s disruption combined with rearranged geopolitical alliances … in motion before covid and appearing more precarious. While we don’t see globalization going away, the rearranging of it is underway and is somewhat inflationary. A desired by-product of all this, shorter supply chains, comes with higher costs.
Additional cost pressures facing the economy are embedded within the transition to alternative energy … this ramp up will be time consuming and costly. Higher labor costs are likely to remain and need to be passed on.
Despite the Fed’s eight rate hikes totaling 450 bps since last March, the US job market is still out of balance limiting the likelihood that the Fed shifts to a dovish policy pivot this year. The tight labor market is rather structural, and the dynamics are unlikely to fade anytime soon amid aging demographics, soft labor market participation, and shifting lifestyle demands. The number of job openings in the US fell slightly last year to 11 million, about 4 million above pre-pandemic levels. At year-end, there were 5.7 million unemployed, suggesting a theoretical 1.9 jobs for each unemployed person.
With one of the key mandated goals of monetary policy set to promote maximum employment, the Fed is already there … evidenced by the lowest US unemployment rate (at 3.4% in Jan) since 1969 despite more layoffs and some cooling in wage growth. Although we anticipate the US unemployment rate rising to 4.2% by the end of the year as the full lagged effect of the Fed’s rate tightening takes effect, we expect the 1 percentage point climb in the jobless rate to be gradual.
Added to this, profit margin expansion has proliferated since covid … reasons appear to be opportunistic, amid less competition, and putting forth more effort to control supply.
In this context, we see the headline US CPI eventually leveling off above the FOMC’s 2 percent goal near 4.0%, an outcome that likely keeps the fed funds target rate elevated … probably at levels equivalent to at least the rate of inflation beyond 2023. Implicit here is that US monetary policy avoids reestablishing negative ‘real’ short-term interest rates (inflation > fed funds) … a policy path that would also keep money market rates, including SOFR, elevated in the 3.5% – 4.0% range.
Sorting out the changing landscape
The pre-pandemic economic and market backdrop, which coincided with ultra-low inflation and highly accommodative monetary policy, is unlikely to return. The abundance of competitive labor, markets that blindly rewarded top-line/volume-driven business models, and indisputable cost efficiencies from globalization appear to have passed. While some of this change predated covid, the pandemic’s fallout accelerated the process.
For monetary policy, the inflationary aftermath of the pandemic woke up reluctant central bankers to the reality that there are severe consequences from too much stimulus.
In attempting to assess what may drive future inflation, it may be helpful to reflect on some key changes underway since the global financial crisis by responding to 3 questions.
- Market elixirs: Quantitive Easing, 0% rates & the Fed ‘Put’
- Low financing costs: Almost fee money
- Rate volatility: Historically low
- Yield curve: Positively sloped
- Financial repression: Issuers benefited most
- Casino mindset in markets: TINA & FOMO
- Dearth of pricing power: More price takers
- Excess labor: Happy to have a job
- Energy sources: Reliable & abundant
- Commodities: Predictable & affordable
- Supply chain: Low cost, non-diverse & JIT
- Cold war dividend: Widened push to globalize
Where are we?
- Inflation: Though moderating, a wakeup call
- Hawkish Fed: Fed Funds target of 4.50 – 4.75% & Quantitive Tightening
- December FOMC minutes: Inflation risks tilted to upside
- Monetary conditions: Mostly tightening
- Less financial repression but Fed Funds rate < YoY CPI
- Recession fear: 6m to 10yr Treasury yields are inverted
- Rate volatility: Off recent peaks but elevated
- Credit spreads: Becoming normal, not cheap
- Tight labor market: Easing up a bit
- Higher wages: Pace of gains have slowed
- Stocks not cheap: Valuations down in ‘22
- Housing market: Activity down, prices off a bit
- Geopolitics: More friction and complexity
- Supply chain: Seeking diversity/dependability
What do we expect for 2023?
- Inflation to ease somewhat but remain sticky
- Restrictive Fed policy. No ’23 rate cuts
- Fed to signal a mild policy pivot in Q4
- Fed funds target to exceed the YoY CPI
- Treasury yield curve to invert from 1-month to 10-years
- Rate volatility to face intermittent spikes
- Unemployment rate to climb slowly
- US economy to slow in a soft landing
- Credit spreads to widen
- Stock market to remain mostly defensive
- More fiscal pressure and focus on US deficit
- More reshoring & nearshoring to fortify supply chains
By the end of 2022, the FOMC had already increased its fed funds target by 425 bps. As noted above, allowing for a 6–9-month time lag for the rate hikes to kick-in likely reduced the impact of that tightening to the equivalent of ~250 bps as of year-end ‘22.
For 2022 overall, monetary policy was at its tightest at y/e despite not yet having achieved full potency. It was expected that rate hikes would create economic headwinds, strong enough to dent economic growth late into 2022 … particularly given H1 ‘22’s mildly negative US real GDP. It didn’t happen. The first release of Q4 ’22 real GDP in Jan showed a 2.9% annual growth rate … and that followed Q3’s higher than expected 3.2% outcome. While Q4 GDP will get fine-tuned further in Feb & Mar, it’s likely to be far from recession territory indicating the US economy headed into 2023 somewhat resilient.
We anticipate only modest real GDP growth this year of around 1% given the full lagged effects of tighter monetary policy taking hold. While a low US unemployment rate and larger nominal wage gains contributed to the economy’s resiliency in the face of inflation, we expect fewer positive tailwinds as this year progresses.
There’s diminished appetite for fiscal expansion amid a record debt load and growing debt service costs. In addition to more Fed tightening yet to come, pandemic savings began to dwindle last year as many stimulus programs ended or wound down. By some estimates, excess savings have fallen in half compared to their ‘21 peak and are likely to be nearly depleted by y/e ’23. At the end of last year, the overall personal savings rate declined to 3.4% of disposable personal income vs 7.5% at the end of ‘21.
The wealth effect took a small hit last year as the value of most financial assets fell. US household net worth, which includes the total value of assets, financial (stocks) and non-financial (residential real estate) less liabilities, ended ‘21 at a record high $150 Tn. According to our estimate, it ended ‘22 at $142 Tn. The $8 Tn drop is just over 5%, which is relatively modest and not much of a headwind considering that household net worth rose by 14% (almost $19) Tn in ‘21 … a record amount.
We expect another hit to the wealth effect this year of approximately 7% as the cumulative effect of Fed tightening weighs on both stocks and home values. This degree of wealth destruction, roughly $10 Tn on top of last year’s $8 Tn estimated loss, would lower the value of US household net worth to ~ $132 Tn by y/e ‘24 … where it was in early in 2021, then reaching a record high.
While lost wealth is a headwind for economic growth, we see this degree of wealth erosion as still relatively benign, taking us back a couple of years, and being both manageable and recoverable particularly given how frothy both stocks and home values became after covid stimulus.
We anticipate sluggishness in the residential housing market this year amid continued constraints on housing supply and affordability. It also appears that pent-up demand from covid’s dislocations has dramatically eased back. We expect mortgage rates (30-yr fixed) to hover between 6.5% and 7% during much of this year as the prospect for a Fed pause on rate tightening reduces the potential for downward pressure on term rates. A relatively sluggish housing market will also reduce the housing multiplier effect on the economy.
Broader growth headwinds, between now and y/e, include the potential for a continuation of softness in some categories of retail, tech, and manufacturing. The manufacturing sector’s been in a downtrend and is burdened by a drop-off in new orders, contracting for the past 5 months. We expect orders to pick up by mid-year due to the need for inventory replenishment. Elsewhere, real consumer spending has been soft for the most part but is likely to stay positive (growing between 1.5% and 2.0%) as low unemployment and somewhat slower inflation enables real wage gains to turn slightly positive.
Weighing further on growth this year, tighter US fiscal conditions are to be expected given the sizeable budget deficit, the record debt load, higher debt servicing costs, confronting the debt ceiling, and fear over the potential that any new fiscal stimulus could reignite an inflation surge. And finally, uncertainty over the Fed, the economic outlook, the debt ceiling, and financing costs should slow capital investment, particularly for lower IRR projects.
The equity markets have rallied so far this year and the S&P 500 is up ~15% since its 2022 low point in mid-Oct. Stocks have recovered largely on the back of last year’s corporate pricing power and in anticipation of a dovish FOMC policy tilt later this year as markets maintained hope that inflation moderates further. With the FOMC’s 2 percent inflation target far off and underlying economic fundamentals generally holding up despite eight Fed rate hikes, it’s still premature to bet on policy accommodation.
A key risk to equities is that moderating inflation doesn’t continue but instead remains stuck, well above the Fed’s inflation target longer than anticipated … or even worse, reignites amid higher commodity prices as China’s economy returns from covid restrictions and Russia’s war in Ukraine drags on. The possibility that the Fed may not succeed at sustainably taming inflation will hang over the stock market as a distraction, and possibly a headwind, given some of the resilience seen so far in the economy following 450 bps of rate hikes.
The uncertainty of where US inflation lands is likely to keep the Fed hawkish for longer and maintain expectations of a recession … a backdrop that could weigh on earnings and stocks. Investor sentiment has only recently become more focused on the potential for more Fed rate increases and the possibility that rates will not be cut this year … issues the Fed has warned about for months.
The uncertainty of recession – and the top-line, earnings, and credit concerns that come with it – have not been at the forefront of the equity market for over 3 months. We expect these concerns to resurface by mid-year as the moderation in annual inflation, seen since last summer, appears likely to stall above the Fed’s inflation goal.
The bullishness over the past 3 months has come from underinvested allocations, premature optimism to the Fed ending its tightening cycle, and a relatively complacent attitude toward the possibility of a tough economic outcome. The ‘Fed put’ is gone, in our opinion, in the event of a notable market downturn. At this point, the Fed would welcome tighter financial conditions. A Fed bailout that might benefit markets would only be tolerated if the financial system was in peril.
We are defensive on US equities for 2023. Given our view that the cooling of US inflation hits a wall later this year, the Fed will delay communicating a dovish pivot … we expect equity markets will become more risk averse, put a greater focus on fundamentals and struggle. For 2023, we see the S&P 500 down 10% … 17% below current levels, which is slightly below the Oct ’22 lows.
While stock market valuations are more attractive than this time last year, the market is not cheap, and the era of free money is over. The S&P 500 P/E ratio of approximately 19.5, while down from 23 a year ago (before rate hikes began), is above the average of the past 25 years. It’s arguably unsustainably high for an economy with low economic growth, the prospect for recession, a Fed that has not ended its inflation fight, and an asset class facing obvious valuation risk as the present value discount effect has changed substantially with the prospect of 5% 1-yr risk-free rates.
While profit margins in many industries were way above historical averages last year initially benefiting from simultaneous inflation and supply shortages, we see margins (and future earnings) vulnerable to weaken this year as hot inflation dissipates, the economy slows somewhat, and unemployment climbs modestly.
From a US interest rate perspective, a weaker equity market of this magnitude (down 10% ytd) would tend to provide marginal support for bonds, sustaining an inverted UST curve in the face of possible policy easing prospects beyond 2023. It would also tighten up financial conditions somewhat without much financial distress and enable the FOMC to finish its job sustainably turning back inflation pressures.
Last year with the Fed ramping up rates and carrying through its inflation fight, 3m, 2-yr, 5-yr, & 10-yr UST yields increased a respective 431, 369, 274 and 237 bps. The visible compression in rate changes, seen here as the maturities lengthen, is reflected in the UST yield curve’s deep inversion where medium and long-term rates are below short-term rates.
There was logic to the inversion, Fed chairman Powell had warned last summer that bringing inflation back to its 2 percent target would inflict some pain to households and businesses … a rise in unemployment and some economic hardship. The warning suggested a serious need remained to address unwanted inflation and that a weaker economy was coming. The markets somehow viewed the warning to suggest that once inflation showed signs of moderating, rate cuts would presumably follow … after October, medium and long-term yields responded by falling noticeably and many stocks rose decisively.
Based on the economy’s overall resilience so far, the US is engaged in either a soft economic landing or the pain Powell warned of is yet to come. The most recent GDP data showed a 2022 3rd and 4th quarter rebound amid a backdrop of pre-pandemic levels of unemployment.
Much of the curve is more inverted currently than at year-end ’22 as the Fed is expected to follow through further on its commitment to tackle inflation with more rate tightening.
We expect the UST curve past 1-yr to shift only modestly by y/e with medium and long-term rates remaining below the front-end as the Fed holds the funds target range at 5.00% – 5.25% after 50 bps more tightening in March and May. A stall in inflation’s cooling with annual CPI around 4% later this year, absent a recession, is likely to limit the ability for further declines in medium and long-term UST yields.
The expected inflation stall combined with the FOMC halting its rate hikes is likely to make the Fed appear less hawkish (than now) in the face of being unable to deliver on its 2 percent inflation goal.
For UST yields, this suggests that by y/e there should be a bit of flattening between 5 and 10-yr yields that hover near 4.0%, in line with where we expect the YoY CPI’s moderation to stall out. This is consistent with our later 2023 expectation of a quieter Fed (on hold), a strong-ish job market, sticky services inflation, and still no recession but increasing signs of economic headwinds.
While rate volatility on USTs has just recently perked up, it remains contained. We see the containment largely due to the continued cooling of inflation, the broad expectation that overall price pressures will continue to ease, and the likelihood that the Fed is near the end of its rate tightening cycle and will then be set to hold its fed funds target … presumably from early May to y/e.
Implied yields on Fed funds and SOFR futures currently peak in Q3, at 5.25% and 5.50% respectively. The futures’ market assessment of fed funds, SOFR, and eurodollars (implied 3m Libor rates) has also recently become more volatile. With unemployment at a > 50 year low and no clear sign of recession, the market’s view of when to anticipate a Fed pivot has become increasingly unsettled as traders attempt to determine how much rate tightening may be appropriate, when rates might eventually be cut, and to what degree. We anticipate this uncertainty to continue and to become more fierce, intermittently, in the coming months.
Treasury Yield Forecast
Two, 5 and 10-year UST yields ended 2022 at 4.43%, 4.00% & 3.88% respectively and are currently 4.66%, 4.09% & 3.88%. The y/e ’22 curve inversion between 2’s & 10’s was minus 55 bps and is currently minus 78 bps.
We anticipate 2, 5, & 10-yr yields ending ’23 relatively bunched up at 4.10%, 3.90%, & 3.85% respectively amounting to a milder 25 bps inversion between 2’s & 10’s. Our expectation that the curve remains inverted at the end of this year reflects a scenario where the FOMC has not yet met its inflation goals with Dec YoY CPI at 4% and the core PCE price index at 3.6%.
Interest rate volatility is mostly hinged currently to the inflation and Fed monetary policy narrative … for the most part, we anticipate that continuing this year. At the margin, however, we are increasingly concerned that geopolitical developments, technical considerations in the UST market, and the debt ceiling matter could stir up rate turbulence.
What could go wrong?
Volatility threat # 1: Geopolitical stress
This month marks the 1-year anniversary of Russia’s invasion of Ukraine. At the beginning of the war, USTs benefited as yields fell amid a flight-to-quality. Although that initial safe-haven flow of capital was not sustained, the war indirectly impacted US interest rates as energy and food supply interruptions contributed to higher inflation pressures and presumably more Fed tightening. Although the war continues and the US commitment to assisting Ukraine has deepened, there’s been minimal flight-to-safety into USTs … scant evidence of any fear trade. While Putin has recently picked up the pace of his war, we have not seen evidence of a return to the UST safe-haven trade. This suggests to us that the conflict, assuming only conventional means of warfare remain deployed, is unlikely to resurface as a catalyst for additional UST demand.
Volatility threat # 2: Technical breach
During last year’s bond market selloff, the 4-decade long decline in UST yields came to an end. This extraordinary, multi-decade bond market rally that preceded it was accompanied by volatility and intermittent selloffs that lifted rates along the way, just not high enough to convincingly negate the overall interest rate downtrend … 2022’s climb in 2, 5, and 10-yr USTs was significant enough to change that. The earlier pattern of a broad multi-year step-down trend in rates was breached as yields shot up. The yield changes observed in the UST market over this lengthy period suggest that 2, 5, & 10-yr UST yields will likely remain above 2.97%, 3.09%, & 3.24% respectively (last seen in Nov ’18) in the event yields resume their post Oct ’22 decline.
We highlight these levels in recognition of the potential for significant interest rate volatility returning in the event any of these levels are penetrated in a declining interest rate scenario. Cost effective hedging and funding opportunities could emerge rapidly at some point in the event a lower term rate environment was to unfold in this manner.
Volatility threat # 3: Debt ceiling
We see the threat of a debt ceiling showdown ahead lifting the fiscal focus this year, both domestically and globally.
This month, the Congressional Budget Office (CBO) warned that the US Treasury could run out of cash before July (the X-date) if Congress fails to act on either lifting or suspending the cap on the $31.4 Tn federal borrowing limit. The warning provided more precise details on the balancing act, and potential timetable, ahead over the uncertainty of tax revenue inflows. An uncertain timeline of June into September possibly sits out there as an uncertain ‘X-date’.
If an agreement is not forthcoming in a planned and negotiated manner, it could be forced on the Congress in a time of crisis. If an 11th hour scramble doesn’t resolve the matter, the Treasury – absent cash – runs the risk of not paying all its bills, including the threat of defaulting on UST obligations … which would be a disaster with global financial repercussions.
While we do not see the debt ceiling issue coming to this, we can envision lots of drama. And amid the theatrics, unwelcome volatility in the financial markets could become disruptive. Interest rate volatility could surge, and yields could both fall and increase … flight-to-USTs and flight-away-from-USTs is possible.
Our optimism on this issue is based on 2 realities. First, there’s a very broad recognition by members of Congress that threatening America’s creditworthiness to leverage political agendas, as urgent and well-intended as they may be, is unequivocally foolish … the US would end up being in far worse shape than it is today if financial stability, here and abroad, was compromised by not attending to a preventable and known crisis. And second, the Congress owns much of this predicament … their purpose and the public trust would be somewhat negated if they allowed known budgetary matters to derail into a crisis. At the end of the day, financial obligations of the federal government are a by-product of the budgetary process that they are intricately involved in and take responsibility for. It makes sense that elected officials support America’s creditworthiness.
Nonetheless, the US faces significant fiscal challenges ahead. Just this month, the CBO projected the US budget deficit could grow by another $19 Tn over the next 10-years amid a sharp rise in entitlement spending. We don’t see 2023 being the year where Washington tackles tough decisions on federal outlays or revenues. Addressing these challenges must occur but for the year ahead, we see the key fiscal item that could shake the bond market mostly isolated to the debt ceiling matter.
If the debt ceiling issue becomes disruptive, even with no default scenario, but demonstrates political dysfunction by the purveyors of the budget, it could set off a ratings agency event (credit watch or worse, a downgrade). The US credit rating was downgraded by S&P 12 years ago when the total US public debt as a percent of GDP was 94%, it’s currently 120%. Back in 2011, the UST market was able to take the downgrade, 1 notch from AAA to AA+ (with a negative outlook) in stride. Today, the surge in debt and interest rates are in the process of significantly lifting federal interest expense burden, a dimension which compounds the challenges ahead. While we do not anticipate the landscape of intractable budget deficits being a direct theme for higher medium and long-term UST yields this year, we are concerned that a ratings agency event on USTs would noticeably lift interest rate volatility.
Interest Rate Forecasts