Analysis: Investors are betting that the Fed will blink higher for longer despite the mantra when the recession hits

15 December (Reuters) – Some investors believe an expected recession will force the Federal Reserve to ease monetary policy next year, even as the central bank forecasts it will hike rates higher than previously expected and hold them there longer will while fighting inflation.

The momentum came into sharp focus following Wednesday’s Fed policy meeting, when it delivered a widely-expected 50 basis point rate hike and projected borrowing costs will rise another 75 basis points by the end of 2023 — half a percentage point more than officials forecast in September.

Such a move would bring the fed funds rate to about 5.1%, a level not seen since 2007, according to the median estimate in the Fed’s quarterly summary of economic forecasts. The fed funds rate is currently in the 4.25% to 4.50% range.

However, interest rate futures markets told a different story as investors bet late Wednesday that the Fed would hike rates further in the first half of 2023 before cutting them to about 4.4% by year-end .

“The Fed is having a hard time convincing markets to move in their direction,” said Ed Al-Hussainy, senior global rates strategist at Columbia Threadneedle, who is betting 10-year Treasuries will continue a recent recovery. “There is… a lack of confidence in the Fed’s ability to move rates well above 5 percent.”

How much higher borrowing costs will rise and whether tightening monetary policy will plunge the economy into recession are questions that have plagued investors for months as the Fed begins its most aggressive rate hike since the 1980s in a bid to dampen rising inflation.

While Fed Chair Jerome Powell said on Wednesday that the Fed’s projections don’t necessarily mean the economy will fall into recession, he did hint that the risk is worth it and that policymakers don’t plan to follow through Cushion interest rate cuts – a message he has repeatedly delivered on previous occasions.

Nonetheless, hopes that inflation would peak and allow the Fed to end rate hikes earlier resonated in markets in recent weeks, prompting a rally in the S&P from its recent lows, the US dollar off a two -Decade high plunged, fueling a strong recovery in battered treasuries.

Benchmark 10-year Treasury bond yields, which move inversely with prices, were recently around 3.5%, compared to over 4.2% earlier this year. The S&P 500 is up 11.4% in the fourth quarter but remains down about 16% for the year. US consumer prices rose less-than-expected for the second straight month in November, data showed on Tuesday.

FIGHT THE FED

“The market moves really describe the challenges they face, which isn’t so much the credibility of fighting inflation as the credibility of being restrictive and sticking to their guns,” said Sonal Desai, CIO of Franklin Templeton Fixed Income, referring while on the Fed .

A BofA Global Research survey of fund managers released this week found that 42% expect short-term yields to fall, the highest proportion since March 2020.

Those forecasting lower rates include fund manager Vanguard, Deutsche Bank and Bank of America, with the latter two forecasting a recession next year and predicting that the Fed will start cutting rates by December 2023.

“Markets believe the Fed needs to ease by the end of next year and nothing from today’s chairman has dissuaded them from that notion,” said RJ Gallo, portfolio manager at Federated Hermes. He is currently overweight US Treasuries and mortgage-backed securities.

Christopher Alwine, head of Vanguard Fixed Income Group’s global credit team, believes the economy will fall into a mild recession in the second half of next year, prompting the Fed to cut rates through the fourth quarter of 2023.

“We don’t think the market is that far off in terms of pricing, but a little ahead in the easing cycle,” he said.

Many investors believe the Fed will stay the course even as the economy falters. The Fed’s economic forecasts showed interest rates falling to 4.1% in 2024, higher than an estimate three months ago.

“The statement and economic forecasts (of the Fed) tell a simple but compelling story: this Fed is not ready to pivot in any meaningful way until it sees sustained and conclusive evidence of a reversal in inflationary pressures,” said Karl Schamotta, chief markets strategist at Corpay.

Franklin Templeton’s Desai takes Powell at his word. She expects the volatility that has rocked bonds this year to continue, in part as investors question the Fed’s commitment to tight monetary policy.

“The market is really conditioned to expect the Fed to step in,” she said. “We have a generation of traders that has never seen the Fed not bail out when the going gets tough.”

Reporting by Davide Barbuscia and David Randall; Additional reporting by Saqib Iqbal Ahmed; Writing by Ira Iosebashvili; Edited by Megan Davies and Edmund Klamann

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