The primary driver for the market’s poor performance in 2022 has been the Fed’s rate hiking campaign to combat inflation, which has raised interest rates. The Fed is clearly in inflation fighting mode, having made three 75 bps rate hikes (on 6/15, 7/27, and 9/21) and going from 0% to 3% Fed funds in a historically fast rate hike campaign.
With inflation readings still high, the question is when will the markets get relief? Investors are looking at the current data (8.5% CPI, unemployment still at 3.5%) and saying “if 3% Fed Funds is not enough, how high will they go? How do we stop inflation?”
Members, led by Chairman Powell, have noted they want to get interest rates into “restrictive” territory to exert downward pressure on inflation. Restrictive means rates are above “neutral”, a rate policy makers feel is between 2% and 3%, centering on 2.5%. The Fed has only just reached restrictive territory. Up until now, it’s just been getting back to neutral. This eventual peak is referred to as the “terminal” rate, or the point the Fed will pause its rate hikes. The market’s estimate of this level has been moving higher all year, and is now around 4.5%, suggesting the Fed rate hikes of 75 bps in November, 50 bps in December, and 25 bps in January.
While the Fed has been aggressive with three straight 75 bps rate hikes, and looks set for a fourth in November, the markets remain focused on the “Fed Pivot”, or when the Fed starts to shift to a less aggressive policy. The positive is that a Fed Pivot does not require a reversal of policy, but merely a sign the Fed is taking its foot off the brake.
The clearest policy pivot would be when the Fed slows its pace of rate hikes from the current 75 bps per meeting pace. This does not mean cutting rates or even stopping the rate hikes, but to simply slow them. This would help the market see a path to pausing rate hikes to allowing the economy to adjust to the new interest rate environment. The result would be for the markets feel that bonds fully reflect the Fed’s terminal rate.
As you can see, the Fed can pivot while rates are restrictive. Also, a pivot does not require the Fed to cut rates, or even stop them. One encouraging sign is that market expectations of inflation have already started to decline.
The chart shows Core CPI, implied inflation (from TIPS), and the 1-year Treasury yield (as a proxy for Fed policy). Combined, the chart captures current inflation (the past), Fed policy (the present), and projected inflation (the future).
Even though inflation has seized the headlines and Fed action is driving the narrative, inflation expectations, as priced by the TIPS market, have dropped from their March peak. At that point, oil was spiking on Russia invading Ukraine, and the Fed was just commencing its rate hikes. Now, with the Fed on its third 75 bps rate hike and a record jump in the 1yr Tsy, markets are pricing inflation coming back down.
The market is debating how much of an economic impact is needed for the Fed to see its moves as working, and thus allow for a Fed Pivot. It is well understood that monetary policy acts with a lag on the economy. Measures vary from three months to a year or more, but six months is a common rule of thumb. That means economic data today, such as unemployment, CPI, or GDP, is driven by where monetary policy was 6 months ago. On 3/30, the Fed had just started rate hikes with its first 25 bps move at its 3/16 meeting, as well as just tapered its QE program to $0 purchases. Today, we have rates at 300 bps and markets pricing at least another 100 more before year end. QT is ongoing. Six months from now, this will be impacting the data. For example, mortgage rates reached 7% on 9/30, compared to 4.9% on 3/31/22 (let alone the 3% range they spent most of 2021), and that will certainly be a drag on housing prices going forward. Oil closed Q3’22 at $79/bbl versus its June peak of $122, and gas prices at the pump have followed it lower. And other prices like lumber, shipping, and car prices have turned lower and will start to filter through the economy and the data. These faster moving indicators, as well as others like falling manufacturing surveys, are registering a slowdown in the economy and an alleviation of inflation pressures.
While the backwards looking data is still alarming, the forwards looking data suggest the rapid rate hikes are starting to impact the economy.
Markets know the Fed is fighting inflation, and as long as that fight is ongoing, there is the risk of economic or financial market disruption. However, markets are forward looking. They know Fed policy acts with a lag, and even a minor shift could indicate the Fed’s is starting to lift its foot from the brake. Early signs of this are evident in the 5yr TIPS breakeven rate falling back towards 2%. This is why markets remain Riveted to the Pivot.
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