With Inflation Offsides, the Fed Keeps Hiking
The Federal Reserve delivered another jumbo-sized rate hike at its meeting this week, lifting the upper bound of the fed funds target range by 75 basis points to 3.25%. Citing the need to bring down inflation and keep it down, the Fed's projection indicates that it's likely to continue raising the rate to a peak level of 4.6% in 2023, implying roughly 150 basis points in additional hikes.
The "dot plot" which is a summary of estimates about the path of the fed funds rate by the 19 members of the Federal Reserve Open Market Committee (FOMC), shows a median expectation for the path or interest rates. It's a marked increase from the June estimates which suggested a peak rate (terminal rate) of 3.75% followed by a modest decline in 2024.
FOMC Dot Plot, as of 9/21/2022
Source: Federal Reserve, Summary of Economic Projections, September 21, 2022.
However, it's notable that the Fed's projection still shows the expectation that short-term rates will drop in modestly in 2024 and further in 2025. It's not the "hike and hold for a long-time" scenario many were expecting. It's indicating a sharper, shorter cycle with short-term rates falling back toward 2.5% over the long-run. Of course, these are just projections, as of today and there is a wide dispersion of views at the Fed. Nonetheless, it appears that the majority at the Fed see rates falling in 2024.
Economy: Recession risks rise
The Summary of Economic Projections (SEP) underscored the Fed's willingness to tolerate the "pain for some households and businesses" that Fed Chair Powell talked about at his speech on policy at Jackson Hole, Wyoming in late August. The Fed is projecting that GDP growth will slow over the next two years with the unemployment rate rising to 4.4% in 2023. The forecasts suggest that the Fed is willing to let the economy fall into recession to get inflation down.
Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents
Source: Federal Reserve Board, 9/21/2022.
Notes: For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. The central tendency excludes the three highest and three lowest projections for each variable in each year. The range for a variable in a given year includes all participants' projections, from lowest to highest, for that variable in that year. Longer Run projections for Core PCE are not collected.
The rapid pace of tightening raises the risks of a more significant downturn in the economy in the near term. Monetary policy works with a lag. Changes in interest rates today can take a year or more to have a significant impact on the economy. Since this has been the fastest rate hiking cycle in decades, a lot of tightening has already taken place and may have yet to work its way through the economy.
This is the fastest rate hiking cycle since the early 1980s
Source: Bloomberg. Federal Funds Target Rate - Upper Bound (FDTR Index), using monthly data.
Note: Lines represent the cumulative change in the Fed funds target rate from the start of each rate hike cycle shown. For the current cycle, the Fed funds target rate has risen 3%, from a 0.25% to 3.25%.
Past performance is no guarantee of future results.
Moreover, the Fed is continuing its quantitative tightening program–allowing its balance sheet holdings of bonds to decline–another form of tightening policy. Finally, this is a global tightening cycle with central banks in many other countries hiking rates as well.
The initial market reaction in the bond market saw short-term rates rise sharply with two-year yields rising as high as 4.12% but ultimately dropping back to the 4% area, while longer-term yields edged lower. While there is room for bond yields to move higher as the Fed tightens policy, we continue to believe that the faster and more forceful the Fed is in hiking rates, the deeper the inversion of the yield curve.
The two-year/10-year yield curve drops to a new low
Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USCY2Y10 INDEX). Daily data as of 9/21/2022.
Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100.
The two-year/10-year treasury yield spread has fallen to -53 basis points–a level seen only a handful of times. Historically, deeply inverted yield curves have been associated with recession. While there is room for intermediate to long-term bond yields to move higher, we believe the market may be close to a peak in yields.
Fed tightening cycles are often characterized by high volatility, especially in riskier segments of the markets. With the Fed moving at a rapid pace, volatility is likely to remain high.