There’s one key assumption undergirding markets at present. Many are resigned to the notion that the Federal Reserve will speed up the process of tapering off its QE asset purchases, so that it can start raising rates in the new year to deal with what it now acknowledges to be a growing problem with inflation. But, and this is the critical assumption, it won’t have to hike rates too much, and can finish the job still below 2%.
On the Fed’s greater haste, the Bloomberg analysis of the probabilities implied by fed funds futures show how expectations have shifted in the last two months. As recently as November, there was seen to be minimal chance of a rate hike before June. Now, the chance of a hike at May’s meeting is well over one in two, and there is one-in-three chance of a rise as early as March:
This helps explain the recent surge in shorter-term bond yields. But longer-term yields have fallen, significantly, despite ongoing elevated inflation forecasts. As this chart shows, 30-year Treasury yields have dropped more than 60 basis points since March, even as 30-year inflation forecasts remained unchanged:
So the implicit expectation is that by moving more quickly and aggressively, the Fed will save itself from having to hike too far and make rates so expensive that they slow down the economy. Hence, many are now braced for a Fed announcement next week that it will accelerate its taper—probably even double the amount that it cuts back asset purchases each week, and be finished as early as March, rather than the more relaxed schedule taking until June.
Something along these lines wouldn’t have too great a market impact. But how safe is the assumption that the Fed won’t be hiking long into the future? Alan Ruskin, foreign exchange strategist at Deutsche Bank AG, suggests it isn’t:
The ‘risk neutral rate’ based off short-term rate expectations is currently below 1.5%, while the Eurodollar strip implies a peak funds rate a little above 1.5% through 2027. If this is correct, a sub 1.75% terminal funds rate, would almost certainly imply a peak real fed funds rate solidly in negative territory for the first time since WW2. At its heart, there is an implied assumption that all the Fed has to do is tap the fed funds brake a mere 150bps, and the economy will slow sufficiently to break the inflation cycle.
To put this in historical perspective, over the four decades since price rises peaked under Paul Volcker, inflation has quite often exceeded the fed funds rate (meaning that the real fed funds rate is negative), but all hiking cycles have ended with the fed funds rate above inflation:
