Higher for longer.
Rates continued to increase this month across the curve as traders embraced the Fed’s message of “higher for longer,” which they have been repeating consistently all month. The policy sensitive 2T increased 70bps to roughly 4.15%, while the 10T increased about 55bps to 3.74%.
Volatility remains elevated as rates have swung significantly on their march higher. The 10T increased 25bps, then retraced 25bps, all in the last five trading sessions of the month.
And equities continue to get pummeled, with the S&P down over 20% year-to-date.
There is little chance for the Fed to achieve a soft landing. As we stated last month, the better question is, how deep into the recession do we get before the Fed pivots and starts cutting rates?
The Fed has made it a point to communicate to the market that they do not expect to cut rates next year, but how much of that is talk versus what they really believe? We know the power “Fed Speak” can have on tightening financial conditions without the Fed even hiking. So they must appear steadfast in their conviction to continue to raise rates and fight inflation, or the market will call their bluff. And the market is still pricing in about one 25bp rate cut by the end of 2023.
The 75bp rate hike and the press statement were pretty dull, so no surprises there. The FOMC members updated their economic forecast (Summary of Economic Projections, or SEP) for the first time since June, which was far more interesting. Spoiler alert, the FOMC participants were optimistic.
Inflation projections not surprising, yet surprising.
As has been repeated ad nauseam, the Fed’s focus is on stomping out inflation, so it is not surprising that its projections show precisely that. It is a little surprising how quickly they expect to get inflation in check, especially given how sticky core inflation continues to be. Core CPI and core PCE for August both came in at 0.6%, up from 0.3% and 0.1%, respectively, in July. The Fed will need inflation to move in the other direction in the next few months to hit their median projection for 2022 PCE of 5.4%.
Unemployment? Nothing to get fired up about.
The Fed was fairly optimistic about the unemployment rate for 2022, only expecting the rate to tick up 0.1% from the current 3.7% level by the end of the year. The Committee did see unemployment increasing to 4.4% for 2023 and 2024, which is a small admission that there will be some economic pain in order to get inflation in check. (The Fed does not project upcoming recessions, so we are stuck interpreting based on the projections.)
But a 4.4% unemployment rate, GDP at 1.2%, and inflation down to 2.8% by the end of 2023 seem a bit aggressive. It certainly sounds like a soft landing, which very few market participants believe is possible at this stage. Even Powell has admitted as much, saying, “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”
Is the GDP glass half-full or half-empty?
The Fed is optimistic about GDP for both 2022 and 2023. The US economy shrank by 1.6% and 0.6% over Q1 and Q2, respectively, yet the Fed is projecting GDP for the year to come in at 0.2%. This would mean GDP for Q3 and Q4 would need to average about 0.9% GDP growth, which will be challenging as the current Q3 GDP forecast from the Atlanta Fed is at 0.3%. Not to mention financial conditions are continuing to tighten over the next few months, creating headwinds for GDP.
Fed Fund Rate.
The median Fed projection is for the federal funds rate to increase another 125bps to 4.25%-4.50% by the end of the year, 1.00% higher than the Committee projected at its June meeting. This would likely mean a 75bp hike in November followed by a 50bp hike in December, but it will depend on the Fed’s reaction to incoming economic data.
The market seems to believe the Fed for this year, with futures pricing in 4.5 hikes by the end of the year (FOMC participants were almost split between 4 and 5 hikes). Interestingly, the market is pricing in 1 rate hike in the first part of next year, followed by a rate cut in the second half of the year, with fed funds ending 2023 at the exact same level as 2022, slightly below the Fed’s projections.
It was only a matter of time before central banks started to capitulate due to deteriorating economic conditions and market dysfunction. The first bank to pivot was the Bank of England, deciding to halt its plans to proceed with QT and instead launch a QE program to restore order in the bond market, where the UK 10Y gilt yield exploded over 100bps higher in a matter of days.
According to the BoE, “The Bank will carry out temporary purchases of long-dated UK government bonds from 28 September…the purchases will be carried out on whatever scale is necessary to effect this outcome.”
Many pointed to the unfunded tax cuts passed by the UK government the week prior. Still, the UK Treasury blamed “significant volatility” in “global financial markets” vs. pointing the finger at the Chancellor.
The BoE did not take further rate hikes off the table, but what does it look like when central banks are re-starting QE while at the same time increasing their policy rate?