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Fed’s no-rate-cut mantra rejected by markets seeing recession

Federal Reserve officials are making a full-court-press effort to convince investors they won’t be slashing their benchmark interest rate before year’s end.

It’s not working.

Money markets are pricing a rate peak around 4.9%, followed by nearly half a percentage point of rate cuts by the end of 2023. That’s despite multiple officials in recent days delivering a sharply contrasting message: Rates are heading above 5% and will stay there all year.

Just last month, Chair Jerome Powell highlighted that history warns against “prematurely loosening policy.” With traders effectively rejecting his narrative, the risk is that exuberance over monetary easing causes Fed officials to tighten even more — if falling market rates undercut their efforts to cool the economy.

“The market thinks the Fed is playing without a playbook, since their forecasts have been wrong before and they’ve downplayed them in the past,”’ said Marc Chandler, chief market strategist at Bannockburn Global, who’s been working in financial markets since 1986. Investors judge that the US is “headed for a recession, and that the Fed doesn’t quite yet get it.”

US Treasury yields are little changed since before the Fed’s policy meeting last month, when officials raised their forecasts for how high the key rate will go. Powell highlighted that 17 of 19 predict a peak of 5% or more, a level above current market rates.

That message was again driven home in recent days. Atlanta Fed President Raphael Bostic said the central bank should raise interest rates above 5% by early in the second quarter and then go on hold for “a long time.” Esther George of Kansas said the Fed should hold above 5% into 2024.

“Fed officials have turned more hawkish because investors aren’t listening to their warnings,” Ed Yardeni, the veteran watcher of the bond market who heads his namesake research firm, wrote in a note to clients. “Perhaps, Fed officials should listen to the bond market.”

One problem is that Powell and his predecessors have each downplayed the relevance of the so-called dot plot of policymakers’ forecasts for the benchmark rate. Another issue is that the Fed’s 2021 forecasts proved woefully wrong in failing to anticipate the rate hikes of 2022.

But markets see easing in second-half 2023

Powell himself played down the dots when he was a Fed governor, and doubled down on that message as he first took the helm of the central bank in 2018. Janet Yellen, when she had charge of the central bank, told the market to ignore the dots in mid-2014. Even Ben Bernanke, who as Fed chief launched the introduction of the dots in 2012, later tried to minimize their policy-signaling value.

Swaps traders see the Fed boosting its policy rate — now in a 4.25% to 4.5% target range — to just under 5% by June and then cutting it to around 4.5% by the end of December. While traders’ pricing of the terminal funds rate, as it’s known, has ebbed and flowed through recent months, cuts have consistently been priced in for before the end of 2023.

Still, in making their official forecasts, primary dealers in US Treasuries as a group aren’t pricing in rate cuts, a survey by the New York Fed showed last month.

Expectations could shift with the December consumer price index report, due out Thursday. Stocks and Treasuries rallied after the past two reports showed slower inflation than forecast.

‘Undoing’ Fed

Minutes of the Fed’s December 13-14 meeting showed participants worried about any “misperception” about monetary policymaking fueling optimism in financial markets that would then “complicate the committee’s effort to restore price stability.”

“Markets are undoing what they are trying to do on rates” by not tightening financial conditions enough, said Conrad DeQuadros, a senior economic adviser at Brean Capital LLC.

Fed officials, in their forecasts released last month, expect the key rate to reach 5.1% this year, according to the median estimate. None forecast rate cuts in 2023.

Nancy Tengler, chief executive and chief investment officer at Laffer Tengler Investments Inc. is one who’s putting her faith — and investment dollars — in the bond market’s signals.

‘Often wrong’

“The Fed is often wrong at turning points, said Tengler, who’s worked in markets for several decades and helps manage $1 billion. “One thing I keep in mind is that the dot plot in September of 2021 didn’t even show the Fed getting to 2% until 2024,” she said, referring to the policy-rate forecast.

Economic data such as Friday’s surprise contraction in the Institute for Supply Management’s services gauge back the view that a recession in the offing and inflation has peaked, she says. “The Fed’s ultimately going to have to catch up.”

© 2023 Bloomberg


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