Disconnect
The Fed pushes back against market expectations.
The markets took a look at the Federal Reserve’s new, and hawkish, forecasts today and seemed to shrug them off. Following today’s “mere” 50 basis-point hike of the federal funds rate to a range of 4.25-4.5%, futures contracts remained relatively unchanged, reflecting a terminal rate of around 4.8% next year and a quick reversal in policy later in 2023. This is not the message Chair Jerome Powell or the Summary of Economic Projections (SEP) gave as the FOMC participants pushed back on investor speculation that they are close to wrapping up the tightening campaign.
The December summary of economic projections held notable adjustments to Fed thinking since the September SEP. GDP growth estimates for 2023 were notched down from 1.2% to barely positive territory at 0.50%; expectations for the unemployment rate rose from 4.4% to 4.6%; and inflation was forecast to stay above the preferred 2% until late 2023/2024. The dots jumped, as well. No less than 17 of 19 FOMC participants now expect the target rate to be in a range of at least 5-5.25% at the end of 2023, in sharp contrast to market pricing that sees the Fed in easing mode by that time.
All the words, both written and spoken, pointed to a hawkish Fed, one that is willing to push the economy to barely positive growth and will continue with rate increases until the right level is reached and one that will not back away too soon.
But the fixed-income markets seem to doubt the Fed’s resolve. Investors appear to be focusing too much on recent softening of inflation number. We are taking the Fed at its word, looking for a peak slightly above 5%, and anticipating slower turnaround than seems to be currently priced into the market.
Quantitative tightening (QT) is still trucking along. The Fed will continue to allow $95 billion per month of securities to roll off its balance sheet. Eventually, QT should incrementally bump up short-term interest rates, as well as reduce bank reserves and usage of the New York Fed’s Reverse Repo Facility (RRP). Counterparty participation of the latter has declined slightly since the November meeting to under $2 trillion, but the Fed opted to keep the rate 5 basis points above the lower bound of the new range, putting it at 4.30%.