It's Never A Straight Path

Volatility ticked back up in February as higher-than-expected inflation data and a surprisingly strong jobs report supported the Fed’s case for “higher for longer”. The policy sensitive 2-year Treasury has jumped over
50bps and the 10-year Treasury has increased more than 40bps since the beginning of the month.

As expected, the Fed hiked the policy rate 25bps on February 1st, bringing fed funds to the 4.50%-4.75% range. This marked a slowdown from the 75bp and 50bp hikes the Fed implemented last year as the central bank approaches the expected peak rate for this cycle. The market is currently pricing in 75bps-100bps of further tightening by September, implying an upper bound for the fed funds rate at 5.50%-5.75%.

Note, outside of the brief Covid recession, the US has never entered a recession when the inflation adjusted
fed funds rate (real fed funds) is below 2.5%. This makes theoretical sense; to restrain an economy, interest rates need to be positive in real terms. The real fed funds rate is currently close to 0.0%, but could increase relatively quickly if the Fed continues hiking rates and inflation falls faster than expected.

• On an annual basis, headline CPI and Core CPI increased 6.4% and 5.6% respectively, both lower than
December’s data.

• MoM CPI jumped from 0.1% to 0.5%, but the overall “disinflation” trend remains intact based on the YoY data, assuming inflation peaked at 9.1% in June 2022.

• Shelter, food, and energy costs accounted for most of the increase.

• The Fed’s preferred inflation gauge, Core PCE, increased 0.6% in January and 4.7% YoY, both higher than the PCE prints for December.

• The US economy added 517k jobs in January, almost three times more than the market expected.

• The unemployment rate dropped to 3.4%, the lowest level in 53 years.

• Wages continue to grow at a 4.0%+ annual rate, but have been on a downward trend since the recent peak of 5.9% in March.

It appears the market was pricing for a straight-line decrease in inflation, but historically that is not how inflation works. There has not been a period of time where inflation does not swing significantly on a monthly basis. It does not follow a linear path up or down, so the monthly data can be a bit misleading. Yes, the month-over-month inflation numbers are a good snapshot of recent price movements, but data for a single month usually does not have a strong short-term correlation with the overall trend. It is often ‘noise’ that distracts from the larger picture.

This is consistent with Federal Reserve Chairman Powell’s statements that the disinflationary process takes time and “is probably going to be bumpy”.

Based on SOFR futures, the market increased bets the Fed will have to take rates to almost 5.5% this year and rates will remain elevated longer than previously anticipated in response to the latest economic data. Investors are now expecting fed funds to peak at 5.4% this year, 50bps higher than forecasted at the beginning of the month.

Market expectations and the Fed’s forecast are now largely in line over the next couple of years.

The majority of Fed members have been hawkish this month, with most officials agreeing that recent inflation data reinforces the fact the Fed needs to further increase the policy rate to ensure inflation moves back down to the 2.0% target. Unfortunately, the most recent economic projections from the Fed were released in December and we will not receive an updated forecast from the committee until next March 22nd. It will be interesting to see if the Fed members increase the peak rate and for how long they anticipate keeping fed funds in restrictive territory.