By Vivien Lou Chen
It took almost four months for financial markets to register the likelihood that US interest rates could climb above 5% by March, the highest level since 2006, but that moment may finally be here. The bond market was one of the first places to see this realization: On Thursday, interest rates on 6-month and 1-year Treasury bills jumped above 4.8% accompanied by a rise in most yields across the Treasury curve. Meanwhile, Fed Funds futures traders briefly raised the probability of a Fed Funds rate target above 5% over the next two months to 41% from 25% on Wednesday. Financial markets, which are usually quick to gauge developments around the world, have taken more than a few moments to absorb the reality of the current inflationary environment in the US, which includes the need for sustained higher interest rates to combat stubborn inflation despite progress in price-cutting gains. Inflation, which stood at 7.1% in November based on the annual CPI headline rate, has fallen for five straight months after peaking at 9.1% in June, but Fed officials remain firm. They have even vigorously rejected market assumptions about how policymakers should set interest rates.
“Old habits are hard to break,” said Rob Daly, director of fixed income at Glenmede Investment Management in Philadelphia, which manages $4.5 billion in fixed income assets. “Sometimes the market takes a long time to adjust to a new reality and we find ourselves in this new reality of a higher inflation environment – not as high as it was, but not 2% either – and a higher interest rate regime without the fiscal or monetary backstop that we’ve had in the past.”
“The market has woken up,” particularly after the minutes of the Fed’s December meeting, recent comments from policymakers and continued strong jobs data, Daly said by phone on Thursday. “The Fed has more wood to chop and investors are adjusting to the reality that they must continue to close the hatches and be cautious.” The prospect of a 5% interest rate has been around since September and October, when Deutsche Bank (DBK. XE) and Barclays both cited the possibility. In November, however, Fed Chair Jerome Powell halted the Treasury bill market’s march towards 5% by saying the pace of rate hikes could slow over the following month. -Plus Scenario through March: Just a day ago, according to the CME FedWatch Tool, that probability was around 25%, up from 41% on December 5th. However, they reassessed their expectations on Thursday after Kansas City Fed President Esther George told CNBC that she sees rates above 5% for some time, prompting traders to push rates back up to mid-afternoon 41% before pulling back to 32%. George’s comments were followed by James Bullard, President of the St. Louis Fed, who said interest rates are not yet tight enough but will be this year and the financial market is overdue for another major reset. Each hike in interest rates has prompted sell-offs in stocks and bonds, with both asset classes ending 2022 with their worst combined total returns since 1872, according to Jim Reid, head of thematic research at Deutsche Bank. Read: 2022 was the “greatest”. Breakaway year in market history when both stocks and bonds plummeted, says Deutsche Bank. That’s the case, despite the fact that minutes from the Fed’s last December meeting specifically mentioned that the market’s “misperception” about how policymakers should respond is complicating the central bank’s efforts to lower inflation. The minutes also indicated that “no participants” in the Federal Open Market Committee believed it would be appropriate to cut interest rates in 2023 — a “demonstrative” statement compared to how the central bank had previously done so described its outlook for rates, said Greg Faranello, head of US rates at AmeriVet Securities in New York. Traders are currently pricing in around 50 basis points of rate cuts from around November — a discrepancy with policymakers that has to do with “how quickly the market thinks the Fed will cut rates once it hits that terminal rate,” Faranello said via phone. “The market says the economy will topple and the Fed will play along and cut rates. I disagree with this scenario and suspect that the market will only reset prices through the data over time.” As of Thursday afternoon, most Treasury yields remained higher, led by a rise in the politically sensitive 1- and 2-year -Interest rates, which reached 4.8% and 4.4% respectively. The rise in short-term rates has outpaced that of the 10-year yield, further inverting the Treasury curve, a worrying sign for the economic outlook. All three major US stock indices fell, weighed down by hawkish Fed comments and strong payrolls data.
-Vivien Lou Chen
(ENDS) Dow Jones Newswires
01-05-23 1340ET
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