Where is the Fed's Peak
Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.
So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets.
The chart also shows another common trait among these hiking cycles which could give a hint as to where the central bank will have to raise the rates. By the end of each business cycle, the Fed cuts off growth by raising the fed funds rate above core inflation 1. Right now core inflation is running at ~6% which is still almost 3% over the fed funds rate of 3.15%. We believe core inflation has likely peaked and will come down over the next 12 months meaning the Fed will be able to meet it in the middle at around the 4.5%-5% range corroborating what futures markets are now pricing in for the first half of 2023. So using all the data we have now our roadmap signals the Fed will continue raising rates by at least another 1% until peaking and beginning to ease up on the pace of hikes in the first half of next year.
In short, we think the Fed will continue tightening policy until the first half of 2023 which means choking off economic growth to tame inflation. For equity markets this means the adjustment period will continue and markets will remain volatile. But the last Fed hike for a cycle, when it does occur, has historically been good news for investors; only during the 2000 cycle did the last Fed hike fail to result in a sustained equity rally. Also we reiterate that the equity market will anticipate this shift well before the data shows an explicit change in the economy (see here). In the meantime strong companies continue to navigate the environment providing cash flow to investors even if stock prices are gyrating by a temperamental market.
In the bond market it means credit quality is paramount and managing duration until rates show signs of peaking will be prudent. We have taken steps to control this in your portfolios and outline it here.
As always we are happy to discuss.
1Core inflation is the change in the costs of goods and services, but it does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are much more volatile.
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