Markets Remain Hawkish on Fed Policy

The markets remain hawkish on Fed policy due in part to hawkish comments last week by several Fed officials. The December 2023 federal funds futures contract (FFZ23) on a yield basis rose sharply by +23 bp last week to 4.70%.

The largest impact was seen from comments last Thursday by St Louis Fed President Bullard, who said he believes that the Fed should raise its funds rate target range to a minimum of 5.00%/5.25%, up by +25 bp from his previous view of 4.75%/5.00%.  Mr. Bullard said, “It’s easy to make arguments that before this is all over you’d have to go to much higher levels of the policy rate” than 5.25%, “But for now I’d be happy to get to the minimal level and that’s why I think the committee is going to have to do more.”

Even worse, Mr. Bullard showed a chart in his presentation based on the Taylor Rule that the federal funds rate will need to rise to between about 5% and 7% to meet the Fed’s goal of being “sufficiently restrictive” to curb inflation near a four-decade high. The mere mention of a 7% federal funds rate spooked the stock market and led to a -1% sell-off in the S&P 500 index ($SPX) (SPY) and the Nasdaq 100 ($IUXX) (QQQ) index last Thursday morning before stocks recovered somewhat later in the day.

The markets are currently discounting a 100% chance of a +50 bp rate hike at the upcoming FOMC meeting on December 13-14, and a small 18% chance of a +75 bp rate hike at that meeting, according to the federal funds futures markets.  After the expected December 50 bp rate hike, the markets and then expecting a 60% chance of another +50 bp rate hike at the following FOMC meeting on January 31/February 1.

The markets currently expect the Fed to hit the peak federal funds rate of 5.05% in June 2023, which would be up by +122 bp from the current effective federal funds rate of 3.83%.  That means the markets at this point are expecting two more +50 bp rate hikes and then a +25 bp rate hike, before the Fed ends its rate-hike regime.  The markets are then expecting the Fed to be forced into a -25 bp rate hike near the end of 2023 as the economy slows, leaving the funds rate at 4.80% at the end of 2023.

The jury remains out on whether the U.S. economy can survive another +125 bp worth of rate hikes without going into a recession in 2023.  The U.S. economy and labor market have so far survived the overall 3.70 percentage point rate hike seen since February.  The FOMC raised its funds rate target by +25 bp in March, +50 bp in May, and then by +75 bp at each of its last four meetings from June through November.

Yet, monetary policy acts with long and variable lags, meaning the recent rate hikes have yet to be fully reflected in the economy.  Moreover, the markets are expecting another +122 bp of new rate hikes. Therefore, the stock market rightly remains worried about the fall-out yet to be seen by the time the Fed ends its rate-hike regime.

Fed policy will take center stage this Wednesday when the FOMC releases the minutes from its November 1-2 meeting.  The FOMC at that meeting announced its fourth consecutive +75 bp rate hike.  The markets will be dissecting the minutes for any signs that the FOMC is backing off its aggressive rate-hike regime given that the consensus is for a reduced +50 bp rate hike at the next meeting on December 13-14.

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