By Mike Dolan
LONDON, Dec 14 (Reuters) – The Federal Reserve, the investment world and the broader economy now have a major sequencing problem.
Even by the Fed’s own admission, the full brunt of its late but brutal credit tightening campaign to curb decades of high inflation has yet to hit the economy. But inflation and business activity are already slowing faster than many thought.
So much so that after Tuesday’s news of a second straight month of surprisingly weak US CPI in November, futures markets are again toying with the idea that Fed rates will be lower late next year than they were at the end of this year.
After annual headline CPI slipped to 7.1% last month and core interest rates also underperformed forecasts to just 6.0%, most economists appear confident that inflation has indeed peaked mid-year.
And what is considered the Fed’s favorite metric, core inflation readings from the personal consumption spending data series, may even have peaked as early as February — though it has since remained at more than double the 2% target.
Equally impressive, inflation expectations in inflation-linked bond markets show all 2, 10 and 30 year indicators hovering around 2.3% – a fraction of the Fed’s targets as it now averages the 2% target over time. Corresponding public readings from New York Fed surveys are also down.
job done? Now we have another game of cat-and-mouse between the central bank and price leaders in the macro economy and financial markets, as to how much the Fed has to do once the medicine it has been administering is already working.
Measuring these amorphous delays between policy decisions and their impact will likely determine whether the fabled “soft landing” can be engineered—or whether we end up with political overkill.
“COCK SCENARIO”
After the CPI read, sounding like a wake-up call for most asset markets, the Fed’s top or final rate, which futures markets implied through May, was pulled firmly below 5%. This suggests the Fed may still have a half-point or less of rate hikes ahead of it once it announces a significant half-point hike to the 4.25% to 4.50% range later on Wednesday.
The story goes on
But perhaps more importantly for credit markets looking ahead and speculators looking to drive the next cycle, implied rates for December/January 2023-2024 fell below those for the same period this year.
This metric is an interesting reflection of what the Fed is trying to do to prevent markets from voluntarily easing financial conditions before the backbone of the inflationary war is broken, thereby undermining the Fed’s fight.
In an attempt to buck that premature easing in late summer, Fed spokesman after Fed spokesman insisted that the job was not done and that no matter how high rates peaked, it would be at least next year no monetary easing.
In doing so, they managed to push rates above late 2022 rates from late 2023 to late September and appeared to protest any attempt to reverse this since.
But with another inflation surprise on the downside, the market is knocking on that door again – now anxiously awaiting any verbal backlash on Wednesday.
Even assuming the market is right to believe that the Fed’s final rate is now back below 5%, there are half a percentage point rate cuts before the end of the year. And 2-year Treasury yields are 4.2%, well below the midpoint of the Fed’s new expected target range of 4.25% to 4.50% on Wednesday.
Aside from the verbal guidance, the Fed’s economic forecasts, which include assumptions about interest rates for the year, will be a key signal for markets to watch on Wednesday.
“We proposed that the median forecast for 2023 would rise to just under 5% — a 25 basis point rise — but this (inflation) report increases downside risks to that outlook,” said PIMCO economist Tiffany Wilding, adding that it has cut its U.S. stocks end-2023 core CPI inflation forecast to 3.3% from 3.7%.
The yield curve between 3-month interest rates and 10-year yields — which many see as a warning of recession, disinflation, or both — hit its deepest inversion in 40 years at around -90 basis points on Tuesday, sending its own pretty clear picture Signal.
So for many investors, further Fed hikes after this week only increase the chances of a deep recession, rather than improving the inflation outlook per se.
If this year’s rate hikes of nearly four percentage points hit the broader economic pulse with the assumed 12- to 18-month lag from announcements, it will hurt until the middle of next year, regardless of what comes next.
Like the proverbial ketchup from a well-shaken bottle, everything can hit at once.
“The Fed has done a lot of aggressive tightening this year, there is a time lag to see the impact of these actions and to remove the risk of excessive tightening it is possible that the Fed will now try to hike rates slowing down,” said Robert Alster, CIO at Close Brothers Asset Management.
The risk of going further and deliberately seeding a downturn on top of disinflation is a concern.
“Lower inflation and negative growth is an extreme scenario that the market is not yet pricing in – which could significantly hurt US corporate margins,” said Florian Ielpo, head of macro at Lombard Odier Asset Management’s multi-asset group.
“We have focused so much energy on the stagflation scenario that we have forgotten the good old debt-deflation scenario: this is a risk we cannot afford to ignore.”
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan, Twitter: @reutersMikeD; Edited by Josie Kao)
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