To a growing faction of Wall Street bond veterans, investors are making a major miscalculation by betting the Federal Reserve’s coming cycle of interest-rate hikes will end with its key rate not too far from where it is now.
As bearishness swept through the markets Thursday after inflation accelerated at a faster-than-expected pace, traders boosted their expectations for where the fed funds rate will wind up to around 2%, up by almost a full quarter-point hike. That still implies a relatively shallow series of increases to below the 2.5% peak in 2018, when the Fed was last tightening monetary policy.
But the speed of the adjustment has some strategists betting that it’s just the beginning of a broader repricing as investors recognize that the Fed is finding itself in a much tougher spot than four years ago, with growth now surging twice as quickly, wages rising swiftly and consumer prices jumping by 7.5% in the year through January, the most in forty years.
All of which may push policymakers to drive rates higher than markets expect, threating to pile more losses on stock and bond investors who’ve grown accustomed to seeing asset prices rally strongly through eras of easy money.
“We have this booming economy with high inflation and a rapid recovery in the labor market—much different relative to the last cycle,” said Michael Darda, the chief economist at MKM Partners, who predicts that the Fed’s overnight rate will peak at about 3.5%. “The Fed is behind the curve this time. They are going to have to do more.”
The widespread expectation of a sharp-yet-shallow rate-hike trajectory has been one force that has kept Treasury yields from rising further. It reflects a view that inflation will abate as the pandemic’s impacts recede and that the Fed will be restrained by structural forces, including a global savings glut and large debt loads that have left major economies with little ability to withstand higher rates.
“I don’t think the funds rate will get to as high as in 2018, because on the way higher stuff will start to happen with financial markets or the real economy that will make the Fed pause and have to stop,” said Joachim Fels, global economic advisor at Pacific Investment Management Co. “We are in this new environment with the real equilibrium rate of interest probably even lower than it was before the pandemic. The pandemic has also pushed up debt around the world and monetary stimulus has inflated asset prices.”
More Losses Ahead
If others are correct—and the Fed pushes the overnight rate to 3% or more—that could send Treasuries toward what would be their first straight back-to-back annual losses since at least the early 1970s, according to Bloomberg’s index. It would also likely pressure stocks, particularly the high-flying growth companies whose heady valuations are particularly sensitive to higher rates.
“If the Fed is really going to be aggressive and get the terminal rate up and shrink their balance sheet, there will be a lot of pressure on stocks for a period of time,” said Peter Tchir, head of macro strategy at Academy Securities.
Treasuries tumbled after the consumer-price index report Thursday, sending two-year yields up 21 basis points to 1.58% amid increased anticipation the Fed will raise rates by a half percentage point next month. But early on Friday, yields across the curve edged lower as traders regrouped and some Fed officials pushed back on the idea of aggressive hike coming.
Also helping yields retrace Friday were comments from centrist Fed officials with views that differ from St. Louis Fed President James Bullard, who rattled markets Thursday when he said he favors raising rates by a full percentage point by July.
San Francisco Fed President Mary Daly said later Thursday that a half-point rate hike “is not my preference,” speaking to Market News.