In the first weeks of the year, financial markets have gone from anticipating a near-term end to the Federal Reserve’s price stability program to the realization that the Fed is not yet done.
The S&P 500 increased by 9.3% through Feb. 2 as part of this broad expectation that the Fed would pause its rate hikes. But since then, robust hiring, strong spending and a re-acceleration of inflation have forced investors to re-evaluate this expectation, and the index dropped by 5% as of Feb. 24.
It wasn’t just the equity markets that might have overreacted to the possible pause in rate hikes. The forward market for three-month rates dipped in January, briefly anticipating a more rapid transition away from rate hikes.
The forward market now anticipates the federal funds rate to reach 5.25% at the Fed’s June meeting and then gradually unwind to just below 4% in two years.
Recent economic reports show an economy that is still red hot, however, and we now expect the Fed to increase its policy rate by at least 75 basis points this spring. That implies a terminal federal funds rate in the range of 5.25% and 5.50% with the risk of a move toward 6% should inflation prove sticky.
The yield curve is pointing to a slowdown…
The prospect of additional rate hikes and an economic slowdown suggests the continuation of an inverted Treasury yield curve.
The yield on 10-year bonds is 80 basis points lower than the rate on three-month T-bills, with the market anticipating slower growth less able to sustain higher rates of interest.
With the inflation rate still above 6%, real, or inflation-adjusted, interest rates remain negative across the curve. That implies investment costs being paid back in deflated-dollar terms, but more work is to be done before the Fed can claim victory over inflation.
…even as yields have rebounded
The yield on two-year bonds, which is highly dependent on expectations for the federal funds rate, dipped to 4.1% in January but then increased to 4.8% in response to the Fed’s February rate hike and the latest inflation data.
Yields on 10-year bonds, which had dipped to 3.4% on the soft-landing sentiment in January, have partially retraced their steps, breaking above 3.9% for the first time since last November.
It’s all about expectations
The direction of this year’s bond market can be seen in changes in inflation expectations.
Model-based estimates at the end of January were for the inflation rate to retreat to 2.6% over the next 12 months, which now seems a bit optimistic compared to the Fed’s 3.1% personal consumption expenditures index projection for this year.
January’s estimates for inflation in 10 years were for only a 2.2% rate, well within reach of the Fed’s stated inflation target of 2%.
At the end of February, long-run estimates of inflation implied by the forward markets are for a 3.65% inflation rate in five years, up a bit from the end of January.
The forward markets are looking at the same data on which the current 10-year yield is based, with 10-year yields since 2019 driven by expectations for Fed policy.
We expect the Federal Reserve to continue to keep overnight rates high for as long as inflation pressures persist.
We now anticipate the federal funds rate to reach 5.5% by June, followed by a period of stable rates before a gradual program of rate cuts is introduced.
That implies a higher cost of credit for businesses and the prospect of an economic slowdown later this year.