Rates Spark: Update on the rates view in light of latest impulses | article

Abraham Smith

The latest French and Spanish inflation numbers are in line with the latest US inflation numbers showing a certain stickiness associated with the inflation narrative. It keeps both the European Central Bank and the Federal Reserve in wandering mode. Here we update the interest rate cycle going forward, giving 5% and 3% as key levels on the horizon for both ends of the curve

The cycle we expect at the front end; initially dominated by hikes

Given what we know, we agree that the Fed will hike 25 basis points per meeting for the next three meetings. The key interest rate range will thus reach a high of 5.25% to 5.50% by June. This is where the Fed stops. It also lines up somewhat with the scatter chart, which will make the Fed feel good. Furthermore, the cumulative delivery of 550 basis point rate hikes (from zero) is a fairly dramatic increase in the cost of debt for households and businesses. Even if it stays like this for just a few months, it will add additional strain and strain to the economy.

The increased leverage costs have an impact effect, a cumulative effect and a persistence burden

The increased leverage costs have an impact effect, a cumulative effect and a persistence burden. Even if players have been through the rate hike process so far and felt some bearable pain, that pain will continue to pile up. In such an environment, US companies will have no desire to go on an investment tour. And while employers are reluctant to lay off employees (due to the difficulty of hiring them in the first place), layoffs will in all likelihood creep in as we progress further into 2023. There’s a moment when inflation and higher interest costs really hit home.

And that’s why we think the Fed will stop, and we also think the Fed will make some sizeable cuts afterwards. Our Chief International Economist James Knightley believes the Fed can get into the rate cut game by the end of 2023 and definitely look out for at least 200bps of rate cuts by 2024. Why? By the third quarter of the year, recognition will grow that the risk of inflation has been significantly reduced, and the Fed will then focus on its second mandate of promoting a strong labor market. By that time, jobs reports will have turned low to negative, requiring some support from the Fed to prevent a (until then) sustained rise in the unemployment rate.

Then we get a pause and then cuts, with 3% and 5% handling key levels for market rates

The 5% handle for the prime rate will in all likelihood be reduced to a 3% handle. In fact, we have the overnight rate bottoming out at 3% in 2024. And before the overnight rate hits 3%, the 10-year Treasury yield is likely to fall before that. If higher rates really start to bite and recessionary sentiment takes hold in the second half of 2023, the 10-year yield is likely to shoot down, reaching the 3% level. However, note that we characterize this as overshoot. What we’re saying here is that the 10-year yield shouldn’t fall below 3%. Or of course it could. But it really shouldn’t. And if it does, it should only be temporary.

We are in a new world here where there are more inflation-prone circumstances

This reflects our view that we are in a new world here, where there are more inflation-prone circumstances that do not justify the super-low interest rates we have had for the last decade and a half. These super lows were caused by the Great Financial Crisis and the response to the pandemic. An average return to the 2% range observed for US 10-year yields over those years doesn’t make much sense going forward. We would see 3% as a more appropriate starting point, which can be broken down as 2% – 2.5% inflation and 0.5% – 1% real interest rates. So this is our target for the bottom of the fed funds rate and if this is the bottom for the fed then the 10 year shouldn’t really fall below it.

Which brings us to the pivot narrative. We were a little frustrated by the market’s obsession with this term in 2022. There is no pivot. There’s a hike phase (ongoing), a pause phase (Q2 and Q3 of this year), and then a cut phase, which we believe will start in Q4 and really kick in into 2024. This phase of cuts is helping to cushion an economy that has finally given way to previous rate-hike pressures. However, it cannot be overstated as the US economy is more vulnerable to inflation going forward. Bringing jobs home doesn’t mean cheaper jobs; De-globalization the same.

That’s based on what we know. Throw in another crisis and we’re off to another tangent. Geopolitics always has the potential to construct that. But until it happens, it cannot be fully discounted. All in all, one of the logical reasons for the US curve’s remarkably early and deep inversion is that longer maturities are a bit nervous about the future. Putin’s war in Ukraine shows how uncertain the whole world is and how the ramifications of such events are becoming global very quickly. And it goes on. The Fed is doing what it can to focus on the US economy. Markets are watching the Fed and lots of other things that move things around; always quite a complex network.