Financial markets were absorbing the realization of how high Federal Reserve policy makers are willing to push interest rates, even if the issue of how long borrowing costs might stay there is unclear — causing stocks to head lower for a fourth straight session, Treasury yields to soar, and the dollar to creep higher on Thursday.
For the first time, traders are pricing in a very slim, less-than-1% chance that the fed-funds rate target could touch 6% by June or the second half of next year.
Meanwhile, they also boosted the chances of the target rising to between 5.25% and 5.5% by March to 23% and likelihood of it getting to between 5.5% and 5.75% by May to 7.8%, according to the CME FedWatch Tool. The Fed’s main policy rate hasn’t been above 5% since 2006, and the last time it was at or above 6% was from March 2000 to January 2001.
The rapid recalibration of expectations was evident across assets a day after the Fed’s policy decision on Wednesday. The Dow Jones Industrial Average
and S&P 500 extended losses while the policy-sensitive 2-year rate broke above 4.7%, turning the Treasury curve more negative in a deeply worrisome signal of an approaching recession. And the ICE U.S. Dollar Index
rose 1.4% to 112.92, one of its highest levels in more than 20 years.
Investors and traders have repeatedly clung to hopes that policy makers might shift away from aggressive interest rate hikes, and Wednesday’s post-meeting statement from the Fed initially reinforced that possibility because of the caveats included about the likely pace of future hikes. Instead, Fed Chairman Jerome Powell threw cold water on those assumptions, saying it was “very premature” to think about a pause in rate hikes and officials have “some ways to go” to tame inflation.
The result was a path of Fed rate increases that will likely be higher than previously expected in September, even if the pace of those moves might slow at some point soon. In other words, central bank officials are likely to be heading for a higher so-called terminal rate, or peak level at which they would end their rate-hiking campaign, and over a longer period of time.
“Powell’s message of a higher terminal rate caught the markets off guard,” said Gary Pzegeo, head of fixed income at CIBC Private Wealth U.S., which oversees $92 billion in assets.
“The last set of Fed projections pegged the terminal rate at 4.75%. If the Fed has to push rates to 5% or higher, and has to keep them there for longer, then yields across the Treasury curve will have to adjust as well,” Pzegeo said in an email. “Markets are pushing their estimate for the terminal rate up to 5.25%, but they still have to address the Chairman’s ‘third phase’: How long do rates need to be restrictive? This could lead to higher rates further out the yield curve. We could see yields for 2 to 5 year Treasuries get above 5% to 5.25%.”
The notion of 5% or higher interest rates — which would make it more expensive for corporations and households to borrow, while further denting the appeal of stocks — comes after a tumultuous year for financial markets.
In August, for example, the idea of a 4% fed-funds rate gained traction. It took a while for the broader financial market to catch up before Treasury yields all began drifting toward that level. From August through October, the S&P 500 dropped, losing its summertime bounce, though the Dow clinched its best October ever. The ICE U.S. Dollar Index
generally trended higher in uneven trading, and the threat of large-scale forced selling in a fragile Treasury market took hold. Meanwhile, more market-based recession indicators blared warnings.
Thursday brought a further inversion of the widely followed spread between the 2- and 10-year Treasury yields, to as little as minus 61 basis points, in an increasingly troubling sign about the economic outlook. Meanwhile, fresh data added to evidence that the economy is slowing, with an ISM barometer of business conditions touching its lowest level since the U.S. lockdowns of 2020.
In the week leading up to the Fed’s policy announcement on Wednesday, financial markets had been trading on renewed hopes of a so-called Fed pivot, or shift away from aggressive rate hikes, but policy makers upset the proverbial apple cart.
The rate-setting Federal Open Market Committee delivered its fourth straight rate hike of three-quarters of a percentage point, and indicated it would take into account “the cumulative tightening of monetary policy” and lagged impact of their actions, among other things, in considering the pace of future increases.
At his press conference, though, Powell focused squarely on the Fed’s “overarching focus” of bringing inflation back to the central bank’s 2% goal and keeping expectations “well-anchored.” “We will stay the course until the job is done,” he told reporters.
“The Fed’s decision and latest guidance are consistent with our recent view that it is too early to position for a dovish pivot in monetary policy,” said Mark Haefele, chief investment officer at UBS Global Wealth Management, and others.
“Overall, we do not believe the conditions are in place for a sustained equity market rally,” the UBS team wrote in a note Thursday. “The Fed, along with other major central banks, looks likely to keep tightening rates until the first quarter of 2023; economic growth will likely continue to slow into the start of the new year; and global financial markets are vulnerable to stress while monetary policy continues to tighten.”
Moreover, “such headwinds have yet to be fully reflected in earnings estimates or equity valuations,” Haefele’s team said. “We now expect global earnings per share to fall by 3% in 2023, versus the bottom-up consensus for 5% growth.”
Plaguing policy makers is a U.S. annual headline inflation rate, based on the consumer-price index, that’s stayed persistently above 8% for seven straight months. Though Fed officials favor other inflation measures, it’s the headline-grabbing annual headline CPI rate that can impact households’ expectations. While a number of analysts have pointed to the likelihood inflation should start to ease, such a scenario hasn’t yet been fully borne out by the data.
“The reality is that Powell simply reiterated what he has been saying all along,” said David Petrosinelli, managing director and senior trader InspereX in New York. “The bigger issue is whether they will be able to leave rates there once they hit the terminal rate. I’m in the camp that doesn’t think they’ll be able to that, should we have what many consider to be a recession.”
Petrosinelli said he expects the fed-funds rate target to get to between 5.25% and 5.5% by the second quarter of 2023, up from a current level of 3.75% to 4%.