Weekly Wisdom – December 15, 2022

By Hightower Great Lakes on December 15, 2022

Markets and the Fed Agreed on Today’s 50 bps Rate Hike, but That’s About All They Agreed on

The Fed announced a 50 bps hike, bringing the federal funds target rate to 4.25-4.5%, which is +425 bps since the beginning of the year when rates were near zero. While the 50 bps increase was expected, and priced in by markets, the Fed’s dot plot and comments sounded hawkish – indicating that “we are not at sufficiently restrictive policy, yet.”

Markets are pricing in rate cuts in 2023 – indicated by the inverted yield curve and 4.3% yield on the 2-year Treasury bond. Meanwhile, the Fed’s dot plot indicates a median 5.1% projected target rate in 2023.

The Fed’s projected 2023 target rate has steadily moved higher through the course of this year’s FOMC meetings.

Quite shockingly, 17/19 Fed members are projecting rates to be above 5% in 2023 – there were exactly zero members who projected rates above 5% in 2023 in their most recent September dot plot. This is a magnificent adjustment in policy expectations from nearly all Fed members.

Chart 1: Fed Dot Plot Indicates Median 5.1% Projected Target Rate in 2023¹

The spread between market rate expectations and the Fed’s projections continues to widen, which also means the yield curve is unlikely to become un-inverted any time soon (our prior Weekly Wisdom dives more into that subject).

For perspective, at this time last year, the Fed’s dot plots predicted a 0.9% fed funds target rate in 2022 and 1.6% target rate in 2023. So, the Fed’s track record of predicting rates with their dot plot models is questionable, at best.

Hawkish Fed Reasoning

Chair Powell continues to emphasize that the pain skews heavily toward price instability. Inflation creates hardship for Americans, and if inflation is not brought down to 2%, then sustainable economic growth cannot be achieved.

Elevated job vacancies and wage growth continue to place upward pressure on inflation. Outside of the tech sector, businesses are reluctant to lay off workers due to the continued hiring challenges experienced since the pandemic. The Fed continues to cite broad price pressures contributing to elevated inflation.

Chart 2: Elevated Labor Costs, Job Openings and Low Unemployment²

Dovish Market Reasoning

The market sees stalling economic growth and falling inflation, amid unsustainable restrictive monetary policy. Financial conditions have tightened, loans are more expensive and the Fed continues to reduce its balance sheet by no longer purchasing securities in the open market.

The Fed no longer buying securities allows for open market price discovery, which has so far led to the 10-year Treasury bond pricing 75-100 bps below the current fed target rate. Investors can currently earn a higher annualized yield by holding a bond for one month than holding a bond for 10 years. This underscores the significant dislocation between markets and the Fed.

The Fed’s projected target rate is now higher than the latest core PCE inflation figure of +5.0% y/y.

Chart 3: Flat GDP Growth Expectations Amid Moderating Core Annual Inflation³

Positioning and Market Reaction to the Fed Delivering a Box of Coal

While CPI data earlier in the week generated a brief rally across equity and fixed income markets, the FOMC meeting put a quick end to the optimistic narrative of an impending Fed pause or pivot.

There continues to be a “long and variable lag” in Fed policy effect on the economy, and markets were expecting the Fed’s comments to reflect a more patient rhetoric. Instead, the Fed emphasized a more restrictive policy than they had indicated in the past and plan to maintain a “restrictive policy stance for some time.”

Equity markets fell upon release of the December FOMC statement, while longer-end rates moved lower as markets price in a greater recession risk and rate cut expectations.

Equity market reaction resulted in defensives, particularly health care, staples and utilities, all outperforming. Communication services, financials and materials sectors all underperformed.

Markets continue to expect a rate cut in 2023, conflicting with the Fed’s expectation to keep moving rates higher. Two Fed members are projecting another 150 bps of rate hikes in 2023, with one of those members expecting the target rate to remain at that 5.6% level through 2025.

Click here to read last week’s Weekly Wisdom (12/7).

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¹ Source: The Federal Reserve (chart). As of December 14, 2022.

² Source: FactSet (chart). As of December 14, 2022.

³ Source: FactSet (chart). As of December 14, 2022.