Why Market Says Fed’s Higher-For-Longer Is Fantasy
Authored by Simon White, Bloomberg macro strategist,
The Federal Reserve will be unable to keep rates at their peak for long, according to the clear message coming from the front part of the yield curve. Nonetheless, the end of Fed tightening cycles tend to be positive for both stocks and bonds, with stocks outperforming.
This week the Fed is likely to raise rates to their highest level, 5.25%, in more than 15 years. This is a significant milestone as it is the highest cycle-peak in rates the Fed has been able to maintain for the longest time – 14 months in 2006-2007. The burning question is: will it be able to repeat this feat, or even come close to it?
The market’s answer is a resounding no. But before we see why, note that the 2006-2007 period was very much the exception, not the rule. The Fed is rarely able to keep rates at their peak for long, looking at tightening cycles going back to 1972. In the cycles after 1990, though, the average period on hold is longer — about four to five months — than cycles pre-1990, when it averaged less than a month.
But we are not in that post-1990 world any more.
These were the NICE (non-inflationary continuous expansion) decades of long and smooth business cycles and less frequent recessions which allowed the Fed to keep rates at a higher level for a longer period.
The yield curve is making it plain we won’t see that this time. The three-month versus two-year segment is signaling the regime has changed. The chart below shows that this curve hits a low as the Fed rate is peaking, but the more negative it becomes – as we saw in the 1970s and early 1980s – the less time the Fed is able to hold rates at their peak.
In the post-1990 tightening cycles, when the Fed was able to keep rates higher for longer, the curve never became as negative, i.e. the pressure from the market for cuts was not as intense. But today the curve is as inverted as it has been since the inflation of 50 years ago, at a time where the Fed was unable to keep rates at their cycle highs for more than two months.
The depth of the yield curve inversion is one reason why the market always ends up forcing the Fed’s hand. Take the 2s10s yield curve. It’s also heavily inverted along with the three-month versus two-year curve.
The 10-year yield can be seen as a proxy for demand and supply of credit and therefore for the underlying health of the economy. As the economy slows from higher interest rates, longer-term yields fall as demand for credit declines, and the curve flattens and inverts. Credit availability also falls as especially smaller banks’ margins are squeezed.
The cumulative impact from a persistently and deeply inverted yield curve mounts through time, until something goes awry and the Fed feels it has no choice but to cut rates.
Secondly, the more inverted the yield curve, the less effective rate hikes become. The curve is the Fed’s transmission mechanism from its base in Washington to the rest of the economy. Raising rates when the curve is heavily inverted is like using rubber to conduct electricity – by the time the rate hike travels down the wire to the real economy, its inflation-combating effect is much diminished. This changes the Fed’s risk-reward calculus in deciding when to cut.
The end of Fed tightening cycles is often unequivocally good for financial assets. Both stocks and bonds typically rally after the last Fed hike, with bonds outperforming stocks.
This is the case even if we only look at tightening cycles before 1990, i.e. those including the high-inflation periods in the 70s and 80s. But in post-1990 cycles, stocks outperformed bonds.
Either way the historical picture is clear that over the last five decades both stocks and bonds rallied after the last Fed hike.
(The Fed may of course hike again after this week’s anticipated rate rise, but it is clear we are much closer to the end than the start of this hiking cycle).
The positive backdrop for financial assets comes when speculators, according to COT data, have a near-record net short in financial assets. Thus if stocks are not derailed in the short term by falling reserve growth or the debt ceiling, their outlook over the next three to six months is constructive.
If the Fed defies the historical odds and keeps rates at peak for an extended period, financial assets might suffer. But the three-month versus two-year curve inversion is telling us the market’s inflation “mindset” is different from the Fed’s. While inflation is likely to remain sticky, it’s unlikely to accelerate enough in the near term for the market to see what the Fed seems to fear.
While that’s the case, it’s more likely something goes wrong and the Fed capitulates. And if past is a prologue then that will happen sooner rather than later.
Tue, 05/02/2023 – 12:59