Fed chair Powell (and many other FOMC members) have made it clear that as of today, the Fed intends to:
- Slow down the pace of hikes
- Reach a higher peak rate than it thought in September
- Stay at peak for longer than normal
How long will policy remain restrictive? This is probably the most important question in determining an outlook. Our belief is that the Fed will reach a peak rate at around 5% (depending on the next couple of months’ inflation data) by March and stay at that peak rate for the rest of the year.
The market agrees on the peak but expects a couple of cuts in the second half of 2023. The discrepancy between the scenario above, vs. those expectations, leads us to the conclusion that the yield curve could continue to invert more between now and the spring (currently at ~80bps but could invert in excess of -100 bps at the two- to ten-year level).
The language used by Powell in his Brookings speech last week is that “restoring price stability will require holding policy at a restrictive level for some time.” The “some time” phrase is intentionally vague, but it is aimed at communicating that the stay at the peak rate is likely to be longer than the few months average of the past several decades. We can infer that the Fed, given what it knows today, does not intend to cut rates in 2023.
Source: Piper. As of 12/7/22.
Financial Conditions … EASING?!
Source: TS Lombard. As of 12/06/22.
Even though the Fed isn’t done hiking rates and certainly not done with QT, the market has already “eased” significantly. Surprisingly, financial conditions are easier now than they were in June, when Fed Funds were at 1.50-1.75%.
If the Fed does slow the pace of rate increases, it is important they signal that this is not the end of the tightening cycle and there is still more work to do. If they fail to communicate that a slowdown is not a pivot, we fear the Fed risks undoing all the hard work it has done this year tightening policy. The Fed can’t have both tightening of policy and loosening of financial conditions — something’s gotta give!
We Said this before, We’ll Say it Again …. The Job Market is Key
Source: Numera. As of 12/06/22.
While both the inverted curve and the manufacturing data are signaling a slowing economy, the constrained labor supply and strong wage growth will likely limit layoffs. And also prevent the unemployment rate from rising as much as we’ve experienced in previous recessions.
Remember, there are 1.7 jobs open for every person looking for a job. With that being said, we believe higher wage inflation over the coming year will pressure the Fed to maintain its policy rate higher than markets expect in the near/ medium term (i.e., no rate cuts in ’23).
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