As expected, the Fed increased the fed funds rate by 25bps to 0.25%-0.50% at its March meeting and revised its median forecast higher to 2.0% by year-end. But the updated dot plot showed a lack of conviction amongst committee members on where rates go from here, with individual forecasts ranging from 1.50%-3.25% (upper bound) by the end of 2022. Chairman Powell continues to say the Federal Open Market Committee (FOMC) will remain “data-dependent,” with every meeting being a “live meeting” with the potential for a 50bps increase.
The futures market is pricing in a faster pace of tightening over the next two years than the Fed, but are also projecting rate cuts to begin in 2024. Based on fed fund futures, traders are forecasting just over 8 hikes this year, putting fed funds at roughly 2.5% in December.
What may be more disruptive to the economy than a 2.0% fed funds rate is the impact of the Fed’s quantitative tightening, which the central bank expects to begin “at an upcoming meeting.”Since 2009 (QE1 began in Nov 2008), equities have been highly correlated to the growth of the Fed’s balance sheet, with an R-Square of roughly 85%.
Any contraction of the Fed’s balance will negatively impact equity markets. As seen above, each time QE programs have concluded, this has been the case.
The Fed has their work cut out to orchestrate a soft landing. The market is full of uncertainty. First, it was COVID, and now it is the Russian-Ukrainian war. COVID disruptions, in conjunction with fiscal and monetary stimulus, have helped push CPI to almost 8.0%, a 40-year high for the inflation gauge (so much for being transitory). With COVID-related supply chains issues still impacting the cost of goods, we now get to layer in the effects of the war in Eastern Europe, such as supply constraints on oil and grains. The results will be passed through to other consumer goods beyond record gas prices at the pump. For example, Russia is the largest exporter of natural gas. This resource represents 60%+ of fertilizer production costs, impacting goods that rely on fertilizer in their supply chains.
Half of the traders we have consulted with are worried that the Fed is not being aggressive enough in tightening the financial conditions to combat the high level of inflation. The other half are concerned that the Fed will hike rates quickly and push the US into a recession. They all agree that the Fed is behind the curve and should have begun normalizing monetary policy six+ months ago.
The US economy grew by 5.7% last year, the most significant single-year increase since 1984, yet the Fed chose to keep rates at near zero percent and continue quantitative easing. The Atlanta Fed is now forecasting Q1 2022 GDP to come in at .09%, a challenging environment to begin tightening financial conditions. Markets are now pricing for a policy error and the inevitable rate cuts. The 5T/10T spread has turned negative and the 2T/10T spread is essentially flat. The futures market is now pricing in rate cuts to begin in 2024, as highlighted in the graph below.
How high will the Fed be able to raise the Fed funds rate?
Interest Rate Caps.
Cap pricing is getting hammered by both the uncertainty in the market, aka volatility, and rates moving significantly higher as traders price in the potential for a more aggressive tightening cycle. Front end rates are up more than 90bps this month, with the bond market on course for one of the worst quarterly routs in 50 years.