There has been a similar scenario playing out all year in the markets. Signs appear that inflation is slowing — first in commodities, then in energy and now in manufacturing prices — and the stock market jumps. And then the bond market puts a halt to the celebration.
Bond investors see through the data and don’t like what they see: Price pressures simply aren’t abating. Stock investors are eager to get out of a big bear market.
What is remarkable is the consistency of this seesawing in the markets. With each iteration, fed funds futures reprice at a higher rate, though the peak remains between March and June 2023. It is bad news for bonds and stocks because it is unclear how high rates are heading.
Historically, when fed funds futures peak, it takes a year before a recession starts. If history repeats, a recession could start by the end of 2023. This is confirmed by the Conference Board’s leading economic indicators (LEI) and the yield curve. Each is currently at negative values. It’s important to note that they have a 100% rate of accuracy for predicting a recession.
So, the market may be right that rates will peak by the middle of next year. But it won’t stop fed funds futures from going higher and higher. The market keeps trading at a higher “peak” rate but is behind the curve because the surprising strength of the data shows the economy can handle 5%, or higher, rates better than foreseen.
Every quarter the Fed releases the Summary of Economic Projections (SEP), which is a forecast of rates, growth, employment and inflation. The SEP is getting quickly outdated because Fed speakers react to incoming data that is stronger and, in turn, use the market as their compass to communicate policy. As a result, yields rise further, responding to global inflation data that is not moderating.
Markets are confronting a common economic problem. Everywhere there is high inflation for the same reasons — snarled supply chains, high energy and food prices, and rising wages. As a result, central banks are ratcheting up interest rates in a manner similar to Brazil’s central bank. Banco Central do Brasil kept on tightening its policy until yields were above inflation. The Brazilian stock market bottomed and is now up 10% this year. In the U.S., rates are far below inflation.
The worry in markets is that the Fed is communicating subtly that it is following Brazil. Seen from the lagged rise in fed funds to the Brazilian Selic rate indicates that a current pace of 75 basis points could become 100 basis points. The next Fed policy meeting on Nov. 2 has a 75-basis-point hike penciled in but the probability of a 100-point move is not zero.
Not a single Federal Open Market Committee member has endorsed a 100-point hike, but there is an appetite within the group to get even faster to the right level of rates to kill off inflation. The president of the St. Louis Fed, James Bullard, flubbed at an Oct. 14 private event organized by Citigroup that front-loading policy is successful because market gyrations have been less pronounced than expected, opening the door to an even faster front-loading.
The head of the Philadelphia Fed, Patrick Harker, forecasts a moderation of the economy next year, which allows raising rates “for a while” and “well above” 4%. Harker said rates must stay in place because the Consumer Price Index tends to fall “like a feather” rather than decline quickly.
The hawkish rhetoric by the Fed and subsequent tightening of policy is causing a historic correction in stocks and bonds. The bear market in each may not end until inflation moderates. Once consumer prices level off, a peak in rates could happen in six to eight months from now, but at a higher rate — 6% to 7%, in my view. Fed speakers have suggested a range of 4.5% to 4.75% is appropriate.
Ben Emons is a managing director of macro strategy at Medley Global Advisors.
