Don’t fight the Fed? Someone better remind the markets

“DON’T fight the Fed” is one of the most hallowed commandments in financial markets – but for most of this year traders and investors have ignored it.

It turns out that playing some Fed policy turn in 2023, rather than guessing any absolute peak rate itself, would have proven lucrative even in the face of constant Fed pushback about possible easing next year.

Even though 2022 will be one of the worst years on record for a range of assets from stocks to US treasuries to corporate bonds, the damage was largely done in the first five-and-a-half months of the year.

That was when, against a backdrop of surging inflation, the Fed’s original pivot to its most hawkish policy stance in decades took investors by surprise and markets crashed.

But since mid-May, when rates futures markets began to bet outright that the Fed would cut rates in the second half of next year, markets have stabilised. They are today pretty much where they were seven months ago – in some cases even a little higher.

To be clear, traders have not swum completely against the Fed. Rates futures have raised the 2023 implied fed funds terminal rate by 400 basis points (bps) to around 5 per cent, and the Fed has raised its “dot plot” forecasts, in a broadly lockstep move.

But since mid-May, the implied 2023 terminal rate has been brought forward to the first half of the year, and rate cuts have been priced into the second half.

The dogged easing wager has remained even as implied futures pricing has accelerated, indicating that markets care more about the Fed pivoting than the actual level of rates.

Seven months ago, the S&P 500 was just below 4,000 points, exactly where it closed last Wednesday (Dec 14); the ICE BofA high yield US corporate bond index is now slightly higher; the ICE BofA aggregate Treasury index is down around 2 per cent, and the US dollar index is little changed.

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Another way of putting it: Since May, investors have not believed the Fed would be as hawkish as it says it would be. They have bet that the Fed would ultimately be forced to ditch its “higher for longer” commitment and cut rates next year, and have traded accordingly.

That is not to say markets would hold up in what is set to be a very sluggish economy next year. But for now, a virtuous cycle between investor risk appetite and looser financial conditions is in play, despite the latest policy tightening and promise of more to come.

This suggests the Fed has a credibility or a communications problem. Or both.

“It was difficult for us to follow the logic of changes to the SEP and the chair’s comments,” Morgan Stanley’s chief US economist Ellen Zentner said, referring to policymaker’s Summary of Economic Projections and chair Jerome Powell’s press conference.

Analysts at TD Securities were a bit more blunt. “The market is calling the Fed’s bluff. Powell and company can harp on a higher terminal and the need to keep it elevated all they want, but the market is trading and is focused on the next (easing) cycle,” they wrote on Wednesday.

The Fed’s messaging last Wednesday appeared a little confused.

Powell pushed back heavily on the idea that there would be any rate cut next year. Policymakers have raised their 2023 inflation forecast to 3.5 per cent, and the median end-2023 fed funds rate outlook has jumped to 5.1 per cent – all very hawkish.

Yet policymakers’ 2023 economic growth forecast has slumped to 0.5 per cent – it was 2.25 per cent in March – and they now see unemployment topping 4.5 per cent. With inflation clearly cooling – incoming economic data are not looking too hot either – you can see why markets are putting the Fed’s hawkishness under intense scrutiny.

Powell’s comments pushed Wall Street lower on Thursday, but interest rate markets largely dismissed them and continued to price in more than 50 bps of rate cuts next year.

The battle lines are still drawn. “The hawks may have come out to play, but markets continue to disobey,” said Investec’s Ellie Henderson, who along with Zentner at Morgan Stanley, expects the Fed to raise rates by only 25 bps in February before cutting in the fourth quarter. REUTERS