The Fed is buying it, just after the fact
December 15, 2022
–Finally a headline on BBG that captures price action: ‘Powell sees rates higher for longer, but the market doesn’t buy it’. I didn’t see the entire press conference, but my takeaways are: The Fed is currently not restrictive enough. No rate cuts until the Fed is confident that inflation is moving down to 2% goal. Seventeen out of nineteen dots for the end of 2023 were above 5% [ten of those were 5.125%].
–So, Dec’23 SOFR ended at 9571.0 or 4.29% and January’24 Fed Funds settled 9561.0 or 4.39%. The market isn’t buying it, it being a terminal rate >5%, OR, the market feels like the economy and inflation are going to decline in a way the Fed doesn’t perceive. The short term horizon leans toward a hike of just 25 at the Feb 1 FOMC. February FF closed UP 1 on the day at 9536, a spread of just 31 to what will be today’s new EFFR of 433. Worth mentioning is that every point on the treasury curve from the 2y out will have negative carry (repo > yield) as the 2y ended 4.226% and tens 3.483%. A headwind of over 75 bps of negative carry on tens is hard to stomach unless you’re pretty sure either the economy is ready to slow a LOT or inflation implodes from here. On that note, it’s worth a mention that the breakeven (ten yr yield vs 10y inflation indexed yield spread) notched a new low just below 220 bps. I.e. the market’s long term inflation expectations are declining, also indicated by recent surveys of, you know, the man in the street (who is now easy to find as he’s living in a tent).
–The Fed itself knows that its restrictive stance now will lead to lower future rates. For end-of-2024 the median dot is 4.1%, 100 bps lower than end-of-2023 median. And, in this case, the market and Fed aren’t too far apart: SFRZ3/Z4 (Dec) is -127 bps, while H4/H5 (March) is -90.5. The problem, as always, lies in the TIMING. The lowest spread is Sept’23/Sept’24 at -147.5.
–Taken together, Powell pretty much said what he had to…because he believes inflation is job one and that [lagging] labor data is still too strong. The market sees a slower economy and lower inflation, as hinted by the CPI report. Now, the Fed is never getting to a FF target over 5% in this cycle. (the MUSH, right? “C’mon Krytonite!!”) The question is, how long can the Fed keep the repo rate over the treasury curve.
–Today’s news includes Retail Sales expected -0.2 m/m. Jobless Claims expected 232k. Industrial Production…skewed higher if you include the need to replenish Christmas inventories of stinger missiles and drones.
BoE, ECB, Norges Bank and SNB.
–In terms of the incredibly tight labor market that Powell always cites, here’s a clip from the Philly Fed:
