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A 6% Fed funds rate? That may be the mother of all shocks to stock markets

US Federal Reserve officials are reinforcing expectations they’ll raise interest rates by a half percentage-point next month (Bloomberg)Premium
US Federal Reserve officials are reinforcing expectations they’ll raise interest rates by a half percentage-point next month (Bloomberg)

Prediction, especially about the future, is difficult, quipped the physicist Niels Bohr. When he made that tongue-in-cheek remark, he certainly didn’t have the markets in mind, but he might have as well talked about recent economic forecasts.

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Prediction, especially about the future, is difficult, quipped the physicist Niels Bohr. When he made that tongue-in-cheek remark, he certainly didn’t have the markets in mind, but he might have as well talked about recent economic forecasts.

And perhaps nowhere in recent memory has the consensus been so wrong: few expected the global economy to rebound as strongly as it did after the pandemic. And for a long time, even the Federal Reserve’s own forecasters were parroting the transitory refrain before it turned too shrill to be proven otherwise. Around March 2021, the European Central Bank’s forecast of inflation one year ahead was a measly 1.3%. Pinch yourself if you must, the actual number turned out to be 7.4%. So much for gazing into the crystal ball and divining a number.

Similarly, what happens if our estimates of the end-of-cycle Fed funds’ rate are horribly wrong? Deutsche Bank, for one, certainly seems to think that may be the case. By the time Chair Jerome Powell and Co. are done raising rates to bring inflation down, the rate will be somewhere between 5% and 6%, its economists reckon (sorry if your coffee spilled as you read that).

Football field

If you lined up all the expectations for the benchmark rate out there together with Deutsche Bank’s assessment, you could probably put up a football field between them. (The market’s own assumption based on the terminal rate is somewhere around 2.45%, which itself is not too far away from the Fed’s longer-term projection of 2.375%.) For good measure, the bank also forecasts a recession in late 2023-early 2024, which again isn’t quite something the rest of the street agrees on.

As forecasts go, it doesn’t get much more radical than that, but a Fed hiking cycle anywhere near that magnitude would send huge shock waves, for markets -- efficient as they are -- typically price in central expectations and not tail risks. If Deutsche Bank is right, it will mean that what we have seen so far this year in Treasuries and U.S. stocks is just the trailer. To watch the full horror movie, though, adult supervision may be required.

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