Double Trouble: Investors Fight the Fed on Two Fronts | Mint

Double Trouble: Investors Fight the Fed on Two Fronts

Federal Reserve Chairman Jerome Powell has had to contend with the highest inflation since the 1980s.
Federal Reserve Chairman Jerome Powell has had to contend with the highest inflation since the 1980s.

Summary

While rate expectations have plunged for next year, further out they are still high.

Investors are betting against the Fed—twice over. The first bet is the sudden turn from expecting the Federal Reserve to keep rates higher for longer to instead expecting rapid and deep cuts next year.

The second bet is almost the exact opposite, that the Fed will have to keep rates much higher in the long run than it says it will. Treasury yields have come down, but at around 4.1% the 10-year yield remains more than 1.5 percentage points above the Fed’s forecast of long-run interest rates.

Both bets go against the popular market dictum: Never fight the Fed. Yet, there are good reasons to think the Fed might be wrong, stronger in my view for the long-term wager than the short-term.

The bet on rapid rate cuts became received wisdom remarkably quickly, which in itself is concerning. Six weeks ago the market was convinced that the Fed would keep rates high next year, with only two rate cuts priced in. Now, five cuts are priced in, against a Fed forecast in September of just one cut from current levels. The most extreme investors expect cuts really soon, with federal-fund futures showing a 14% chance of a rate cut in January, according to CME Group’s FedWatch Tool.

That’s an incredibly fast turnaround from mid-October, when futures traders put a 40% chance on another rate rise next week. That’s something policy makers themselves expected in their last forecasts, in September, but which is now priced with less than 3% likelihood.

The reason so many expect rapid Fed cuts is that inflation has come down; there are increasing signs of stress in parts of the economy most exposed to higher rates; and Fed officials have been more willing to discuss the idea, having previously dismissed it. All the arguments make sense, and the failure of policy makers to push back against the market moves itself suggests the Fed might have capitulated on higher-for-longer rates.

There are good reasons for caution, too. Markets have changed course very rapidly based on not a lot of evidence. One extra month of data since October is a paltry basis for assessing the economic outlook even in normal times, let alone after three years of extreme economic volatility. Investors seem remarkably confident that inflation will continue to come down rapidly, just a couple of months after they were convinced it wouldn’t.

Make enough bets and of course one of them will eventually turn out right, but the market has been dead wrong about imminent Fed easing several times in the past two years. It could be again.

The market’s disagreement with the Fed goes further than just a different outlook for the economy. There’s also a split on how to assess what economists call the Fed’s “reaction function," how it responds to any given economic result.

Luigi Speranza, BNP Paribas chief economist, argues that the Fed will track falling inflation, keeping after-inflation interest rates stable. “They cut because inflation slows and not cutting would tighten [financial] conditions further," he says. Many agree with him.

The opposite argument is that the Fed is psychologically scarred by having completely missed the signs of inflation two years ago. That’ll leave policy makers erring on the side of higher rates.

Fed Chairman Jerome Powell has been “very clear that he wants to go down in history as the second Paul Volcker, not the second Arthur Burns," said Garry Evans, chief strategist, global asset allocation, at BCA Research. Volcker jacked up rates to fight inflation in the early 1980s, while Burns had his arm twisted by the White House to keep rates low in the early 1970s.

The second bet, that the Fed is badly wrong about the long run, also involves disagreement about both the economic outlook and the Fed’s reaction function.

I’ve been arguing for a while that investors were underestimating the long-run inflationary pressures, but the market has finally come around to my way of thinking in recent months. Gone is the belief—once espoused by former Treasury Secretary Larry Summers—that the economy would return to the prepandemic “new normal" of superlow rates. The reality of governments addicted to deficit spending, higher investment needed in a deglobalizing world, higher military spending, demographics and more-powerful unions all mean more inflationary pressure, and so higher interest rates to avoid actual inflation.

The strange thing here isn’t that the market thinks rates will be higher than before. It’s that the Fed doesn’t. Its September forecast predicted long-run interest rates at 2.5%, an after-inflation, or real, rate of 0.5%. Investors think the real rate in the long-run (calculating by looking at inflation-adjusted bond yields for the five years starting in five years’ time) will be close to 2%.

Some of the gap between the Treasury market and the Fed’s prediction is accounted for by the extra yield investors demand to compensate for the glut of bonds coming from the government as it borrows to fund the deficit. But the rest is the market saying that the Fed has got it wrong, and ought to raise its long-run rates prediction—unless it is going to allow more inflation and raise its 2% target.

The Fed next week could resolve both issues. The most bullish case would be to say that rate cuts are possible by the spring of next year, and markets will be paying close attention to any sign that Powell is becoming more dovish. Long-run rates will get less airtime, but don’t forget that if the Fed is right about that long-term interest rate, then 10-year and 30-year bond yields are far too high.

Write to James Mackintosh at james.mackintosh@wsj.com

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