Fool Me Once

The market may finally be overestimating the expected path of policy after two years of persistently underestimating the Fed’s willingness to hike. Recent data suggests that economic growth and employment continue to steadily increase even as inflation is clearly trending lower. This suggests a softening labor market is not necessary to lower inflation and raises the bar for additional tightening. At the same time, financial conditions are notably tightening with the steady rise in longer dated interest rates and the strengthening dollar. In effect, the market has been hiking rates without the Fed and may potentially hike too much. This post suggests that the Fed’s hiking cycle is done and that rate cuts will come sooner than the market expects.

Softly Landing

Recent data suggests that inflation is moderating even as economic growth and employment remain robust. Policy makers postulated that rapid rate hikes would slow the economy, increase unemployment, and also dampen inflation. But instead aggressive rate hikes coincided with economic growth that continues above trend, and an unemployment rate that remains around multi-decade lows. Even interest rate sensitive sectors like single family housing and motor vehicles have shown months of steady growth after an initial decline last year. At the same time, inflation has moderated significantly and is moving towards the Fed’s target.

Key indicators of inflation have steadily moderated and are most recently increasing at rates seen prior to 2020. Core PCE on a month over month basis most recently printed at 0.1%, a rate that is compatible with an annual 2% rate. Wage gains from the most recent non-farm payrolls show a 0.2% monthly gain that is comparable to rates prior to 2020. This suggests that the wage heavy core service ex-shelter measure of inflation that is closely watched by the Fed will also continue to moderate. While inflation did not moderate according to the Fed’s playbook, it is still very clearly slowing. This does not mean that inflation will ultimately stabilize at 2%, but it does raise the bar for additional rate hikes. This is particularly the case when financial conditions are already being tightened by market forces.

Wages and Core PCE are rising at pre-2020 rates.

The Market Can Also Tighten

Longer dated interest rates and the dollar are tightening global financial conditions even in the absence of Fed action. While short-term interest rates have steadily risen, interest rate sensitive sectors of the economy are much more impacted by the level of longer dated interest rates. The sharp rise in short-term rates does not even appear to have meaningfully impacted equities, which are not too far from record highs. Long dated rates stayed range bound for a year, but have recently risen to levels not seen in over a decade. This will raise the borrowing costs for a range of borrowers and have more direct impact on economic conditions. The move in Treasury yields also appears to be dragging other sovereign bond yields upwards and is thus tightening financial conditions abroad.

10 year yields were range bound for a year before rising towards multi-year years.

A resurgence of dollar strength also tightens global financial conditions through its impact on dollar financing. Dollar strength has been found to tighten global financial conditions, in part due to its negative impact on the balance sheet of foreign dollar borrowers. When the dollar appreciates, foreign companies with dollar debt suffer a decline in their net worth in local currency terms. The decline in net worth reduces their access to credit by lowering their credit worthiness and also negatively impacts the health of their bank lenders through higher default risk. A strengthening dollar is thus negative for global growth, which impacts the U.S. economy through international trade and commodity prices.

The dollar peaked last October and remained range bound for a year before moving higher.

Wrongfooted

Markets participants may finally be listening to the Fed just when they should be skeptical. Market pricing over the past two years has persistently pushed back against the Fed’s “higher for longer” path and stubbornly priced both relatively low terminal rates and aggressive rate cuts. This paradoxically made rate hikes even more likely by easing financial conditions and in effect stimulating the economy. Market pricing is now largely in line with the September dot-plot, which guides towards one additional hike even as recent data has been very encouraging. The rise in longer dated yields and strengthening dollar do not appear to have been anticipated by Fed officials and raise the prospect of financial conditions becoming too tight.

Longer dated rates and the dollar are impactful on economic conditions, but they are only some what influenced by the Fed. They are also influenced by the dollar amount of Treasury issuance and the tenors issued. While not within their responsibilities, Treasury and Congress can tighten financial conditions through their actions. There is a risk that their actions can overtighten, so the Fed may have to act as a balancing force by cutting sooner than expected. The timing and extent of the cuts will depend on how high longer dated yields rise.